UNITED STATES
SECURITIES & 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 quarterly period ended September 30, 1998
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 0-25580
DIAMOND MULTIMEDIA SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0390654
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2880 JUNCTION AVENUE, SAN JOSE, CALIFORNIA 95134
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (408) 325-7000
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 outstanding of the registrant's common stock at
September 30, 1998 was 35,137,697.
DIAMOND MULTIMEDIA SYSTEMS, INC.
INDEX TO FORM 10-Q
PART I - FINANCIAL INFORMATION:
ITEM 1- Financial Statements
Consolidated Balance Sheets as of September 30, 1998
and December 31, 1997
Consolidated Statements of Operations for the three
and nine months ended September 30, 1998 and 1997
Consolidated Statements of Cash Flows for the
nine months ended September 30, 1998 and 1997
Notes to Consolidated Financial Statements
ITEM 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations
PART II - OTHER INFORMATION
ITEM 1 - Legal proceedings
ITEM 2 - Changes in securities
ITEM 3 - Defaults Upon Senior Securities
ITEM 4 - Submission of Matters to a Vote of Security Holders
ITEM 5 - Other Information
ITEM 6 - Exhibits and Reports on Form 8-K
SIGNATURES
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
September 30, December 31,
1998 1997
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents........................ $74,596 $85,929
Short-term investments........................... 3,123 4,136
Trade accounts receivable, net of allowance
for doubtful accounts of $2,063 and $2,440
as of September 30, 1998 and December 31, 1997. 81,926 98,777
Inventories...................................... 52,145 78,647
Prepaid expenses and other current assets........ 14,256 6,350
Income taxes receivable.......................... 6,342 24,929
Deferred income taxes............................ 24,596 14,679
------------ ------------
Total current assets........................ 256,984 313,447
Property, plant and equipment, net............... 26,783 15,216
Other assets..................................... 28,110 3,616
Goodwill and other intangibles, net.............. 4,543 5,275
------------ ------------
Total assets................................ $316,420 $337,554
============ ============
LIABILITIES
Current liabilities:
Current portion of long-term debt................ $48,031 $36,455
Trade accounts payable........................... 75,213 98,764
Accrued liabilities.............................. 28,546 17,667
Income taxes payable............................. 197 2,274
------------ ------------
Total current liabilities................... 151,987 155,160
Long-term debt, net of current portion............. 1,605 1,873
------------ ------------
Total liabilities........................... 153,592 157,033
------------ ------------
STOCKHOLDERS' EQUITY
Preferred stock, par value $.001; Authorized -
8,000 shares at September 30, 1998 and
December 31, 1997; none issued and outstanding.. -- --
Common stock, par value $.001;
Authorized - 75,000 at September 30, 1998 and
December 31, 1997; Issued and outstanding -
35,138 at September 30, 1998 and 34,491 at
December 31, 1997................................ 35 34
Additional paid-in capital......................... 312,689 307,877
Distributions in excess of net book value.......... (56,775) (56,775)
Accumulated deficit................................ (93,121) (70,615)
------------ ------------
Total stockholders' equity...................... 162,828 180,521
------------ ------------
Total liabilities and stockholders' equity.... $316,420 $337,554
============ ============
The accompanying notes are an integral part of these consolidated condensed
financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ---------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
Net sales........................ $123,200 $92,028 $481,743 $257,413
Cost of sales.................... 122,817 73,850 419,271 242,767
---------- ---------- ---------- ----------
Gross profit............... 383 18,178 62,472 14,646
---------- ---------- ---------- ----------
Operating expenses:
Research and development....... 8,135 5,899 22,395 18,121
Selling, general and
administrative............... 23,231 16,474 70,136 61,557
Amortization of intangibles.... 244 172 732 2,831
Write-off of intangibles....... -- -- -- 9,938
Restructuring expenses......... -- -- 1,384 --
---------- ---------- ---------- ----------
Total operating expenses.. 31,610 22,545 94,647 92,447
---------- ---------- ---------- ----------
Income (loss) from operations.... (31,227) (4,367) (32,175) (77,801)
Interest income, net............. (12) 388 481 1,426
Other income (expense), net...... (402) 50 (457) 783
---------- ---------- ---------- ----------
Income (loss) before provision
(benefit) from income taxes.... (31,641) (3,929) (32,151) (75,592)
Provision (benefit) from income
taxes.......................... (9,465) (1,376) (9,618) (22,979)
---------- ---------- ---------- ----------
Net income (loss)................ ($22,176) ($2,553) ($22,533) ($52,613)
========== ========== ========== ==========
Net income (loss) per share:
Basic..................... ($0.63) ($0.07) ($0.65) ($1.54)
Diluted................... ($0.63) ($0.07) ($0.65) ($1.54)
Shares used in per share
calculations:
Basic..................... 34,990 34,389 34,863 34,274
Diluted................... 34,990 34,389 34,863 34,274
The accompanying notes are an integral part of these consolidated condensed
financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED; IN THOUSANDS)
Nine Months Ended
September 30,
----------------------
1998 1997
---------- ----------
Cash flows from operating activities:
Net loss............................................. ($22,506) ($52,613)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization..................... 5,313 6,631
Provision for doubtful accounts................... (2,162) 691
Provision for excess and obsolete inventories..... (20,711) 7,093
Gain (Loss) on disposal of fixed assets............ (3) 287
Write-off of intangibles.......................... -- 9,938
Deferred income taxes............................. (9,917) (21,161)
Changes in assets and liabilities:
Trade accounts receivables........................ 19,248 33,859
Inventories....................................... 51,473 (15,597)
Prepaid expenses and other assets................. (6,849) 2,494
Income taxes receivable........................... 18,587 --
Trade accounts payable and other liabilities...... (27,009) 305
---------- ----------
Net cash provided by (used in) operating
activities.................................... 5,464 (28,073)
---------- ----------
Cash flows from investing activities:
Purchases of property and equipment................. (15,276) (5,788)
Sale of Micronics building.......................... 6,310 0
Purchase of Micronics, net of cash acquired......... (21,755) 0
Purchase of DigitalCast, net of cash acquired....... (2,060) 0
Other equity investments............................ (1,150) --
Purchases of short-term investments................. 1,013 --
---------- ----------
Net cash used in investing activities............. (32,918) (5,788)
---------- ----------
Cash flows from financing activities:
Proceeds from issuance of common stock.............. 4,814 1,593
Repurchases of common stock......................... (1) (7)
Proceeds from term loans and revolving credit
facilities...................................... 78,344 100,942
Payments and maturities of term loans and
revolving credit facilities..................... (66,413) (89,929)
Repayments of capital lease financings.............. (623) (601)
---------- ----------
Net cash provided by financing activities......... 16,121 11,998
---------- ----------
Net increase (decrease) in cash and cash equivalents... (11,333) (21,863)
Cash and cash equivalents at beginning of period....... 85,929 120,147
---------- ----------
Cash and cash equivalents at end of period............. $74,596 $98,284
========== ==========
Supplemental Disclosure of cash flow information:
Income taxes paid during the period................. $3,760 $1,400
========== ==========
Interest paid during the period..................... $1,844 $783
========== ==========
The accompanying notes are an integral part of these consolidated condensed
financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared by the Company in accordance with generally accepted accounting
principles for interim financial information and pursuant to rules and
regulations of the Securities and Exchange Commission. In the opinion of
management, all adjustments (consisting only of normal recurring
adjustments) considered necessary for a fair presentation have been
included. These financial statements should be read in conjunction with
the Company's consolidated financial statements and notes thereto
contained in the Company's Form 10-K for the fiscal year ended December
31, 1997.
Operating results for the quarter ended September 30, 1998 may not
necessarily be indicative of the results to be expected for any other
interim period or for the full year.
2. INVENTORIES
Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market. Inventories consisted of (in thousands):
September 30, December 31,
1998 1997
------------ ------------
Raw materials ............. $17,292 $29,876
Work in process............ 25,574 40,286
Finished goods............. 9,279 8,485
------------ ------------
$52,145 $78,647
============ ============
The Company had approximately $3 million of inventory in excess of its
normal short-term needs for certain product lines at September 30, 1998.
Management has developed a program to reduce this inventory to desired
levels over the near term; however, it is reasonably possible that the
program will not be wholly successful and that a material loss could
ultimately result on the disposal of this inventory. No estimate can be
made of the range of amounts of such loss.
3. COMPUTATION OF NET INCOME (LOSS) PER SHARE
Basic EPS is computed as net income (loss) divided by the weighted
average number of common shares outstanding for the period. Diluted EPS
reflects the potential dilution that could occur from common shares
issuable through stock options, warrants and other convertible
securities. Common equivalent shares are excluded from the computation
of net loss per share where applicable as their effect is antidilutive.
The following is a reconciliation of the numerator (net loss) and
denominator (number of shares) used in the basic and diluted EPS
calculation:
(Dollar amounts, in thousands)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ---------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
Basic:
Net income (loss).............. ($22,176) ($2,553) ($22,533) ($52,613)
Average Common
Shares Outstanding........... 34,990 34,389 34,863 34,274
---------- ---------- ---------- ----------
Basic EPS........................ ($0.63) ($0.07) ($0.65) ($1.54)
========== ========== ========== ==========
Diluted:
Net income (loss).............. ($22,176) ($2,553) ($22,533) ($52,613)
Average Common
Shares Outstanding........... 34,990 34,389 34,863 34,274
Stock options.................. -- -- -- --
---------- ---------- ---------- ----------
Total shares..................... 34,990 34,389 34,863 34,274
Diluted EPS...................... ($0.63) ($0.07) ($0.65) ($1.54)
========== ========== ========== ==========
Common equivalent shares of 54,000 and 833,000 have been excluded from
the calculation of dilituve earnings per share for the three and nine
months ended September 30, 1998, respectively, as their effect is anti-
dilutive.
4. MICRONICS ACQUISITION
On June 26, 1998 the Company accepted for payment 11,616,380 shares of
common stock of Micronics Computers, Inc. ("Micronics") at a price of
$2.45 per share, or approximately $28.6 million. On July 9, 1998, the
Company, through a wholly owned subsidiary, effected a merger with
Micronics pursuant to Section 253 of the Delaware General Corporation
Law. The Company estimates the total cost of the acquisition of all the
shares of Micronics to be approximately $31.6 million. Cash payment for
Micronics shares was delivered the first week of July, 1998. Micronics is
a supplier of high-performance system boards and multimedia peripherals
for personal computers. The acquisition was treated as a purchase for
accounting purposes. The Company's operating results for the three month
and nine month periods ending September 30, 1998 include Micronics
results for the entire three months ending September 30, 1998. Also
included in the nine month period ending September 30, 1998 are
activities for the period June 27, 1998 to June 30, 1998, which were not
material to the Company. As a result of the acquisition, the Company
recorded approximately $1.4 million in restructuring charges for the
three months ending June 30, 1998 to reflect severance and outplacement
costs, the cost of closing the Micronics building and moving certain
employees to existing Company facilities, and other integration expenses
specifically associated with the acquisition. These actions were carried
out over the three months ended September 30, 1998 and no liability for
such restructuring charges remains.
The Company's consolidated balance sheet as of September 30, 1998
reflects a preliminary allocation of the purchase price of Micronics.
This resulted in an increase in cash, inventory, accounts receivable,
other current assets, fixed assets and current liabilities. The fair
market value of assets acquired were originally estimated to total $24.7
million while liabilities were $11.6 million. The difference between the
acquisition cost, including approximately $1.1 million in acquisition
expenses, and the fair market value of the acquired assets net of
acquired liabilities will be allocated between in process technology
expense and goodwill upon the completion of a valuation study. At the
time of filing this Form 10-Q, the valuation study is still in progress.
When the study is completed at the end of 1998, a charge to in-process
technology expense will be recognized. The Company currently estimates
that this charge will be between $5 million and $7 million.
5. LITIGATION
The Company has been named as a defendant in several putative class
action lawsuits which 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. Certain
executive officers and directors of the Company are also named as
defendants. The plaintiffs purport to represent a class of all persons
who purchased the Company's Common Stock between October 18, 1995 and
June 20, 1996 (the "Class Period"). The complaints allege claims under
the federal securities laws and California law. The plaintiffs allege
that the Company and the other defendants made various material
misrepresentations and omissions during the Class Period. The complaints
do not specify the amount of damages sought. The Company believes that
it has good defenses to the claims alleged in the lawsuits and will
defend itself vigorously against these actions. These cases are in the
early stages and no trial date has been set. The ultimate outcome of
these actions cannot be presently determined. Accordingly, no provision
for any liability or loss that may result from adjudication or settlement
thereof has been made in the accompanying consolidated financial
statements.
The Company has been named as a defendant in a lawsuit filed on October
9, 1998 in the United States District Court for the Central District of
California. Plaintiffs are 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 alleges 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 does not comply
with the requirements of the AHRA. On October 16, 1998 a hearing was held
and the Court issued a Temporary Restraining Order preventing the Company
from manufacturing or distributing the Rio product for a period of ten days.
On October 26, 1998 a hearing was held to determine if a Preliminary
Injunction should issue to further restrain the Company until the conclusion
of the suit. The court denied the motion and refused to restrain the
Company from manufacturing and distributing the Rio product. The RIAA has
filed a notice that it intends to appeal the Court's ruling to the United
States Court of Appeals for the Ninth Circuit. No schedule has been set for
any briefing or other action on the appeal. No provision for any liability
or loss that may result from adjudication or settlement of this action has
been made in the accompanying consolidated financial statements.
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. In
the opinion of management, the ultimate disposition of such proceedings
will not have a materially adverse effect on the Company's consolidated
financial position or future results of operations.
6. COMPREHENSIVE NET INCOME
The Company has adopted the provisions of Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income",
effective January 1, 1998. This statement requires the disclosure of
comprehensive income and its components in a full set of general-purpose
financial statements. Comprehensive income is defined as net income plus
revenues, expenses, gains and losses that, under generally accepted
accounting principles, are excluded from net income. The components of
comprehensive income which are excluded from net income are not
significant, individually or in the aggregate, and therefore, no separate
statement of comprehensive income has been presented.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The discussion and analysis below contains trend analysis and other
forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934. Actual results could differ materially from those projected in the
forward-looking statements as a result of the risk factors set forth
under "Certain Factors That May Affect Future Performance" below and
elsewhere in this report.
The following discussion should be read in conjunction with the
Company's consolidated financial statements and the notes thereto. All
references to years represent fiscal years unless otherwise noted.
Overview
Diamond Multimedia Systems, Inc. ("Diamond" or the "Company") designs,
develops, manufactures and markets multimedia and connectivity products
for IBM-compatible personal computers ("PCs"). The Company is a leading
supplier of graphics and multimedia accelerator subsystems for PCs, and
is expanding its position in the interactive multimedia market by
providing advanced solutions for home, business and professional desktop
computer users, enabling them to create, access and experience compelling
new media content from their desktops and through the Internet. Diamond
accelerates multimedia from the Internet to the hard drive with products
that include the Stealth series of media accelerators, the Monster series
of entertainment 3D and audio accelerators, the Fire series of
professional 3D graphics and SCSI accelerators, and the Supra? series of
modems. Headquartered in San Jose, CA, Diamond has sales, marketing and
technical facilities in several locations including Vancouver (WA),
Albany (OR), Atlanta (GA), Dallas (TX), Singapore, Sydney, Hong Kong,
Seoul, Tokyo, Starnberg (Germany), Saarbrecken (Germany), Paris, and
Winnersh (U.K.). Diamond's products are sold through regional, national
and international distributors as well as directly to major computer
retailers, VARs and OEMs worldwide.
Net Sales
Net sales for the third quarter of 1998 increased $31.1 million (34%)
to $123.2 million compared to $92 million for the third quarter of 1997.
Net sales for the first nine months of 1998 increased $224.3 million
(87%) to $481.7 million compared to $257.4 million for the corresponding
prior year period. The increases in net sales for both periods were
primarily attributable to shipments of the Company's graphics accelerator
products, modems and motherboard revenues associated with the Company's
purchase of Micronics Computers, Inc. at the end of the second quarter.
As a percentage of total net sales, international net sales
represented 43% of net sales in the third quarter of 1998 compared to 41%
of net sales in the third quarter of 1997. For the first nine months of
1998, international sales were 45% of total net sales compared to 37% in
the same period of 1997. Sales growth was 40% in Europe and 35% in other
international markets (Asia and Latin America) in the third quarter of
1998 compared to the third quarter of 1997. For the first nine months of
1998, net sales in Europe grew 163% compared to the first nine months of
1997, while net sales in other international markets grew 57% for the
same period. European sales were 33% of total net sales in the third
quarter of 1998 and 34% of total net sales in the first nine months of
1998, compared to 31% in the third quarter of 1997 and 24% for the first
nine months of 1997. Other international sales were 10% of total net
sales in the third quarter of 1998 and 11% of total net sales for the
first nine months of 1998, compared to 10% for the third quarter of 1997
and 13% for the first nine months of 1997.
The transition of mainstream PC graphics subsystem architectures from
2D graphics and the PCI bus to 3D graphics and the accelerated graphics
port (AGP), which began in 1997 and is expected to continue through 1998,
as well as the SGRAM-to-SDRAM memory transition, has led to excess
inventory of PCI and SGRAM-based products at the Company and in certain
distribution channels. When combined with seasonal softness in the
personal computer market and competitive pricing pressures, the Company
experienced lower average selling prices and lower gross margins than
originally anticipated during the third quarter of 1998. These market
conditions also resulted in price protection charges continuing to be
higher than expected and selling and marketing expenses to be higher than
planned.
Inventory levels of the Company's products in the two-tier
distribution channels used by the Company ("Channel Inventory Levels")
generally are maintained in a range of one to three 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, when demand is slower, sales
are lower and products are abundant, then Channel Inventory Levels tend
toward the high end of the months-of-supply range. Frequently, in such
situations, the Company attempts to ensure that distributors devote their
working capital, sales and logistics resources to the Company's products
to a greater degree than to those of competitors. Similarly, the
Company's 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 are more likely to occur and,
should they occur, are more likely to be severe. Further, in such an
event, high Channel Inventory Levels may result in substantial price
protection charges. Such price protection charges have the effect of
reducing net sales and gross profit. As planned, the Company took steps
to bring its Channel Inventory Levels down to a more desirable level
during the third quarter. This affected revenue in the third quarter due
to lower shipment levels and price protection charges associated with
aggressive pricing moves. The Company estimates that worldwide Channel
Inventory Levels were reduced by approximately $13 million during the
third quarter. While the Company believes that its Channel Inventory
Levels for many of its products are appropriate at this time, there are
certain products which currently have a Channel Inventory Level that is
higher than desirable. The Company plans to further reduce Channel
Inventory Levels on these products during the fourth quarter which may
adversely affect fourth quarter performance. The Company estimates and
accrues for potential price protection charges on unsold channel
inventory. However, there can be no assurance that these estimates or
accruals will be sufficient. Should the estimates or accruals not be
sufficient, additional price protection charges may be required, the
result of which could have a material adverse effect on operating results
during the fourth quarter of 1998.
Gross Margin
Gross margin for the third quarter of 1998 decreased $17.8 million to
$0.4 million (0.3% of net sales) compared to $18.2 million (19.8% of net
sales) in the third quarter of 1997. For the first nine months of 1998,
gross margin increased $47.8 million to $62.5 million (13% of net sales)
compared to $14.6 million (5.7% of net sales) in the first nine months of
1997. The decrease in gross margin in the third quarter of 1998 compared
to the third quarter of 1997 was caused by a number of factors including
general slowness in the industry and highly competitive pricing
pressures. The increase in year to date gross margin reflects negative
gross margins earned in the second quarter of 1997 due to technology
transitions (2D only graphics to 2D/3D graphics, higher speed modems and
consumer uncertainty regarding connectivity standards), seasonal
slowness, and competitive pressures. Further, gross margin positively
impacted in the first nine months of 1998 by significantly higher
shipment volume levels over which indirect manufacturing costs were
absorbed.
Research and Development
Research and development (R&D) expenses increased $2.2 million (38%)
to $8.1 million for the third quarter of 1998, compared to the third
quarter of 1997. For the first nine months of 1998, R&D expenses
increased $4.3 million (24%) to $18.1 million, compared to the first nine
months of 1997. As a percentage of sales, R&D expenses were 6.6% and 5.3%
in the third quarter of 1998 and 1997, respectively, and 8% and 7.5% in
the first nine months of 1998 and 1997, respectively. These increases
were primarily due to higher personnel-related expenses and the material
and outside service costs associated with new product development,
including products that will offer various functions or combinations of
functions including graphics, digital video, 3D animation, 3D CAD, sound,
modem, telephony and other functions increasingly being implemented on
personal computers.
Selling, General and Administrative
Selling, general and administrative (SG&A) expenses increased $6.8
million (41%) to $23.2 million for the third quarter of 1998, compared to
the third quarter of 1997. For the first nine months of 1998, SG&A
expenses increased $8.6 million (14%) to $70.1 million, compared to the
first nine months of 1997. These increases are primarily due to increases
in sales and promotional expenses during the first nine months of 1998.
As a percentage of net sales, SG&A expenses were 18.9% and 16.7% in the
third quarters of 1998 and 1997, respectively, and 22.3% and 25.4% of net
sales for the first nine months of 1998 and 1997, respectively. The
increases in SG&A in absolute dollars for both the third quarter of 1998
and the first nine months of 1998, when compared to the same periods in
1997, were primarily attributable to higher selling and marketing
expenses. Certain of these expenses, especially expenses attributable to
channel sales incentive programs, are directly proportional to increases
in channel sales experienced between the two periods. In addition, end-
user mail-in rebates were used extensively in the third quarter of 1998.
Personnel related expenses have also increased during 1998.
Restructuring Expenses
The Company incurred restructuring expenses of $1.4 million in the
second quarter of 1998 associated with the purchase of Micronics. These
expenses related to the integration of the Micronics business into
Diamond, especially severance and out placement fees as well as the cost
of consolidating the remaining Micronics employees into existing Diamond
facilities.
Amortization of Intangible Assets
The Company incurred amortization expense of $0.24 million in the
third quarter of 1998 compared to $0.17 million in the corresponding
prior year period. The increase in amortization expense in the third
quarter of 1998 is primarily due to the amortization of the Company's
purchase of Binar Graphics, Inc. in November 1997 which resulted in $2.0
million in goodwill. Amortization expense for the first nine months of
1998 was $0.73 million compared to $2.83 million in the same period of
1997. The decrease is primarily due to the write-off of $9.9 million of
intangible assets during the third quarter of 1997 which significantly
reduced the remaining outstanding balance to be amortized. These expenses
relate to amortization of purchased technology and goodwill from the
acquisitions of Supra Corporation and SPEA Software AG, which occurred in
the third and fourth quarters of 1995, respectively. This decrease in
expense was offset in part by amortization expense arising from Company's
acquisition of Binar Graphics, Inc. Amortization expense will increase in
future periods due to the purchase of Micronics. Exact amounts are not
currently available pending a valuation study to allocate the purchase
price in excess of net assets and liabilities between goodwill and in
process technology expense. This study was not yet complete prior to
publication.
Net Interest Income and Other Expense
Net interest expense was minimal in the third quarter of 1998 compared
to net interest income of $0.4 million in the third quarter of 1997. Net
interest income was $0.5 million and $1.4 million in the first nine
months of 1998 and 1997, respectively. Net interest income declined due
to higher interest expense incurred because of larger average borrowings
outstanding during the first three quarters of 1998 compared to the first
three quarters of 1997. Net other expense was $0.4 million in the third
quarter of 1998 compared to a minimal net other income during the third
quarter of 1997. For the first nine months of 1998, net other expense was
$0.5 million compared to net other income of $0.8 million during the same
period of 1997. These differences were primarily due to proceeds from
the settlement of a lawsuit during the third quarter of 1997 and costs
from the settlement of a lawsuit during the third quarter of 1998.
Benefit for Income Taxes
The Company's effective tax benefit rate in the third quarter of 1998
was 30% compared to an effective tax benefit rate of 35% for the
corresponding period in 1997. The Company's effective tax benefit rate in
the first nine months of 1998 was 30% compared to an effective tax
benefit rate of 30% for the first nine months of 1997. The effective tax
rate in the third quarter of 1997 and the first nine months of 1997 would
have been 35% if not for the write-off of goodwill and existing
technology, which are not deductible for tax purposes. Differences from
the statutory rate consisted principally of the effect of state income
taxes, federal tax-exempt interest income and the research and
development tax credit.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents decreased by $11.3 million during the first
nine months of 1998. Operating activities provided $5.4 million in cash.
The primary sources of cash were decreases in inventories, trade accounts
receivable and income taxes receivable. Significant uses of cash include
reductions to trade accounts payable and other liabilities, reductions to
the provisions for excess and obsolete inventory and doubtful accounts,
and increases in deferred taxes and prepaid assets.
The Company used $32.9 million in cash from investing activities. The
primary investment was the purchase of Micronics, including acquisition
costs, for $21.8 million net of cash acquired. Additional equity
investments used of $3.2 million, primarily for the Company's investment
in Not Limited, Inc., a developer of wireless data communication
technologies including Diamond's HomeFree products, and the purchase of
DigitalCast, the developer of Diamond's internet audio appliance sold
under the name Rio. In addition, the Company has purchased $15.3 million
in fixed assets during the first nine months of 1998 compared to
purchases of $5.8 million in 1997. The increase is primarily due to the
Company's investment in a new enterprise-wide business management,
resource planning and decision support system. The Company successfully
converted to this new system in early October 1998. The Company sold for
$6.3 million a building and real estate acquired in its purchase of
Micronics. Net maturities of short term investments yielded $1.0
million.
Net cash provided by financing activities was $16.1 million. Primary
sources of cash included $78.0 million from term loans and revolving
credit facilities and proceeds of $4.8 million from the issuance of
common stock. These proceeds were partially offset by payments and
maturities of term loans and revolving credit facilities of $6.4 million.
At September 30, 1998, the Company had $74.6 million of cash and cash
equivalents and $3.1 million of short-term investments. Further, as of
such date, the Company had lines of credit and bank credit facilities
totaling $59.3 million, of which $9.9 million was unused and available.
At September 30, 1998, the Company was in default with its loan covenants
regarding tangible net worth and profitability. Waivers for these
violations are pending.
The Company expects to spend approximately $17 million for capital
equipment in 1998, principally relating to computer and office equipment
and including, in particular, an enhanced enterprise-wide business
management, resource planning and decision support system. In addition,
the Company acquired fixed assets with a fair market value estimated at
$7.1 million as a result of the purchase of Micronics.
The Company believes that its cash balances and available credit under
existing bank lines will be sufficient to meet anticipated operating and
investing requirements for the short term. There can be no assurance that
additional capital beyond the amounts currently forecasted by the Company
will not be required nor that any such required additional capital will
be available on reasonable terms, if at all, at such time or times as
required by the Company.
YEAR 2000 COMPLIANCE
Many existing computer systems and applications, and other control
devices, use only two digits to identify a year in the date field,
without considering the impact of the upcoming change in the century. As
a result, such systems and applications could fail or create erroneous
results unless corrected so that they can process data related to the
year 2000. The Company relies on its systems, applications and devices
in operating and monitoring all major aspects of its business, including
financial systems (such as general ledger, accounts payable and payroll
modules), customer services, infrastructure, embedded computer chips,
networks and telecommunications equipment and end products. The Company
also relies, directly and indirectly, on external systems of business
enterprises such as customers, suppliers, creditors, financial
organizations, and of governmental entities, both domestic and
international, for accurate exchange of data. The Company recently
completed the first phase of a project to upgrade the computer hardware
and software it uses to operate, monitor and manage its business on a day
to day basis. At the end of the third quarter, the Company's operations
were converted to this system on an integrated, world-wide basis. This
effort was undertaken to significantly improve the tools and information
available to manage the Company. These tools have the added benefit of
managing data with dates beyond December 31, 1999 as indicated by the
vendors. The Company continues to test such capabilities as part of its
post-implementation process. This testing is expected to be completed
during the first half of 1999. The Company's current estimate is that the
costs specifically associated with this testing and validation process
will not have a material adverse effect on the result of operations or
financial position of the Company in any given year. However, despite the
Company's efforts to address the year 2000 impact on its internal
systems, the Company has not fully identified such impact or whether it
can resolve it without disruption of its business and without incurring
significant expense. In addition, even if the internal systems of the
Company are not materially affected by the year 2000 issue, the Company
could be affected through disruption in the operation of the enterprises
with which the Company interacts.
CERTAIN FACTORS THAT MAY AFFECT FUTURE PERFORMANCE
In addition to other information in this Form 10-Q, the following are
important factors that should be considered carefully in evaluating the
Company and its business.
Potential Fluctuations in Future Operating Results
The Company's operating results have fluctuated significantly in the past
on a quarterly and an annual basis and are likely to continue to fluctuate
significantly in the future depending on a number of factors. The
accompanying sections explain in greater detail certain important factors
that the Company has identified which may affect the future performance of
the Company.
The Company develops products in the highly competitive PC multimedia,
and communications markets, including the graphics, video, sound, audio,
modem, system boards and home networking segments. These products are very
susceptible to product obsolescence and typically exhibit a high degree of
volatility of shipment volumes over relatively short product life cycles.
The timing of introductions of new products in one calendar quarter as
opposed to an adjacent quarter can materially affect the relative sales
volumes in those quarters. In addition, product releases by competitors and
accompanying pricing actions can materially and adversely affect the
Company's revenues and gross margins.
The Company sells its products to retail customers (mass merchandisers
and large chains who sell products primarily off-the-shelf directly to end
users), retail distribution customers (distributors which resell to smaller
retail chains and large individual end users) and OEM customers (customers
which use the Company's products in conjunction with other products to
produce complete computer systems for sales through both direct and indirect
distribution channels to end users). Reliance on these indirect channels of
distribution means that the Company typically has little or no direct
visibility into end user customer demand. OEM customers tend to provide the
Company with forecasts for product requirements but actual order lead times
remain less than 90 days. Retail and retail distribution customers
typically do not forecast product requirements and order lead times are
typically very short, as these customers tend to reorder for stock in
quantities that approximate recent sales volumes. Accordingly, this means
that future operating results are dependent on continued sales to customers
where the vast majority of the normal volume of orders are placed with the
Company within the same calendar quarter, and frequently within a few days,
as the requested date of shipment by the customer.
Because the lead times of firm orders are typically short, the Company
does not have the ability to predict with any certainty the future operating
results of the Company. Therefore, sudden changes that are out of the
control of the Company such as general economic conditions, the actions or
inaction of competitors, customers, third party vendors of operating system
software, central processing unit hardware, and independent software
application vendors can have and have had material adverse effects on the
Company's performance.
Other factors which may have a material adverse effect on the Company's
future performance include the management of growth of the Company, rapid
declines in the price of components used by the Company, latent defects that
can exist in the Company's products, competition for the available supply of
components, dependence on subcontract manufacturers, dependence on and
development of adequate information technology systems, intellectual
property rights and dependence on key personnel.
Each of these factors is discussed more thoroughly in the accompanying
sections and all of these sections should be read carefully together to
evaluate the risks associated with the Company's Common Stock. Due to these
factors, it is likely that the operating results of the Company in some
future quarter or quarters will fall below the expectations of securities
analysts and investors. In such an event, the trading price of the
Company's Common Stock could be materially and adversely affected.
Revenue Volatility and Dependence on Orders Received and Shipped in a
Quarter
The volume and timing of orders received during a quarter are difficult
to forecast. Retail and retail distribution customers generally order
without forecasts on an as-needed basis and, accordingly, the Company has
historically operated with a relatively small backlog. Moreover, the Company
has emphasized its ability to respond quickly to customer orders as part of
its competitive strategy. This strategy, combined with current industry
supply and demand conditions as well as the Company's emphasis on minimizing
inventory levels, has resulted in customers placing orders with relatively
short delivery schedules and increased demand on the Company to carry
inventory for its customer base. This has the effect of increasing such
short lead time orders as a portion of the Company's business and reducing
the Company's ability to accurately forecast net sales. Because retail and
retail distribution customers' orders are more difficult to predict, there
can be no assurance that the combination of these orders, OEM's orders, and
backlog in any quarter will be sufficient to achieve either sequential or
year-over-year growth in net sales during that quarter. If the Company does
not achieve a sufficient level of retail and retail distribution orders in a
particular quarter, the Company's revenues and operating results would be
materially adversely affected.
Also, at any time and with no advance notice, during periods of
uncertainty in the personal computer industry's outlook for future demand or
pricing, the Company's customers may choose to draw down their inventory
levels thereby adversely impacting the Company's revenue during the period
of adjustment. The second and third quarters of 1997 comprised such a period
due to the transition from older slower speed modems and 2D graphics
products to new higher speed modems and 3D graphics products. In the current
transition of mainstream PC graphics subsystem architectures from 2D
graphics and the PCI bus to 3D graphics and the accelerated graphics port
(AGP), which began in 1997 and is continuing through 1998, controller and
memory chip selection and the timely introduction of new products have been
and will continue to be critical factors. The Company was significantly
affected by the PCI-to-AGP transition and the SGRAM-to-SDRAM memory
transition in 1998, which resulted in significant pricing pressures on the
Company's remaining PCI-based and SGRAM-based graphics inventory and by
significant price protection claims associated with such price declines.
Also, as is common in the personal computer industry, a disproportionate
percentage of the Company's net sales in any quarter may be generated in the
last month or weeks of a quarter. As a result, a shortfall in sales in any
quarter as compared to expectations may not be identifiable until at or near
the end of the quarter. In this regard, the Company's results for the
second and third quarters of 1998 were less than expected due to less than
expected shipments of the Monster 3D II product at the end of that quarter
due principally to sudden order cancellations during the final week of the
quarter. In addition, from time to time, a significant portion of the
Company's net sales may be derived from a limited number of customers, the
loss of one or more of which could adversely impact operating results.
Notwithstanding the difficulty in forecasting future sales and the
relatively small level of backlog at any given time, the Company generally
must plan production, order components and undertake its development, sales
and marketing activities and other commitments months in advance.
Accordingly, any shortfall in net sales in a given quarter may materially
impact the Company's operating results and cash balances in a magnified way
due to the Company's inability to adjust expenses or inventory levels during
the quarter to match the level of net sales for the quarter. Excess
inventory could also result in cash flow difficulties as well as added costs
of goods sold and expenses associated with inventory write-offs or sell-
offs. Conversely, in its efforts to adjust inventory levels to a slower
order rate, the Company may overcorrect its component purchases and
inventory levels, thereby experiencing periodic shortages of inventory and
delivery delays, and negatively impacting its net sales, market share and
customer satisfaction levels in the current quarter or in future quarters.
There can be no assurances that such an occurrence will not adversely impact
the Company operating results.
Recently the company announced a shift to a short cycle inventory model
in an effort to reduce price protection and inventory value exposures as a
result of rapid downturns in customer orders. This will result in less
inventory being carried in Company warehouses and by distribution customers.
Consequently, the Company may not be able to react quickly enough to sudden
increases or shifts in demand for a given product with the result that
revenue may suffer.
Declining Selling Prices and Other Factors Affecting Gross Margins
The Company's markets are characterized by intense ongoing competition
coupled with a past history, and a current trend, of declining average
selling prices. A decline in selling prices may cause the net sales in a
quarter to be lower than the revenue of a preceding quarter or corresponding
prior year's quarter even if more units were sold during such quarter than
in the preceding or corresponding prior year's quarter. Accordingly, it is
likely that the Company's average selling prices will decline, and that the
Company's net sales and margins may decline in the future, from the levels
experienced to date. (See also Short Product Life Cycles; Dependence on New
Products) The Company's gross margins may also be adversely affected by
shortages of, or higher prices for, key components for the Company's
products, including its modems, 3D graphics accelerators, home networking
adapters, internet music players and 3D audio accelerators, some of which
have been impacted from time-to-time by a scarcity in the supply of
associated chipsets and other components. The availability of new products
is typically restricted in volume early in the products' life cycle and
should customers choose to wait for these new versions, the ability of the
Company to procure sufficient volumes of these products to meet customer
demand is unlikely. Such a failure to meet demand is likely to have a
material adverse effect on the revenues and operating margins of the
Company.
In addition, the Company's net sales, average selling prices and gross
margins will be adversely affected if the market prices for certain
components used or expected to be used by the Company, such as DRAM, SDRAM,
SGRAM, RDRAM, or flash memory, DVD drives, multimedia or communications
controller chips or bundled software, decline more rapidly than the Company
is able to process component inventory bought earlier at higher prices into
finished products, book and ship the related orders, and move such products
through third-party distribution channels, some of which may be price
protected, to the final end-user customer. The Company experienced such
declining prices and reduced margins in the second and third quarters of
1998 due to the effect of product transitions, including the PCI-to-AGP
transition and the SGRAM-to-SDRAM memory transition. Competition from
products based on SDRAM memory, which has lower manufacturing costs than
SGRAM based products, resulted in sharply declining selling prices for SGRAM
based products. This led to material charges for declining inventory values
and price protection for channel inventory. These charges had a material
adverse effect on revenues, operating margins and operating results.
Conversely, an increase in the price of semiconductor components that are in
scarce supply, such as high-speed DRAMs, may adversely impact the Company's
gross margin due to higher unit costs, and a decrease in the supply of such
semiconductor components may adversely impact the Company's net sales due to
lower unit shipments.
Seasonality
The Company believes that, due to industry seasonality, demand for its
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 the Company's sales consist of sales into the
retail/mass merchant channel, that PCs become more consumer-oriented or
entertainment-driven products, or that the Company's net sales becomes
increasingly based on entertainment-related products. Also, to the extent
the Company is successful in expanding its European operations, it may
experience relatively weak demand in third calendar quarters due to
historically weak summer sales in Europe.
Management of Growth
In recent years, the Company has experienced a significant expansion in
the overall level of its business and the scope of its operations, including
manufacturing, research and development, marketing, technical support,
customer service, sales and logistics. This expansion in scope has resulted
in a need for significant investment in infrastructure, processes and
information systems. This requirement includes, without limitation: securing
adequate financial resources to successfully integrate and manage the
growing businesses and acquired companies; retention of key employees;
integration of management information, product data management, control,
accounting and telecommunications and networking systems; consolidation of
geographically dispersed manufacturing and distribution facilities;
coordination of suppliers; rationalization of distribution channels;
establishment and documentation of business processes and procedures; and
integration of various functions and groups of employees. Each of these
requirements poses significant, material challenges.
The Company has a minority ownership (at 49.5%) with Philips
Semiconductor (at 50.5%) of a 3D graphics semiconductor design subsidiary,
SP3D. The Company's 49.5% ownership of SP3D is carried on the Company's
balance sheet at approximately $3.4 million. Philips Semiconductor has full
day-to-day operating management control of SP3D and holds the majority of
seats on the SP3D board. There can be no assurance that the Company will be
able to achieve a reasonable return on this asset, or that the asset will
not need to be written down, in whole or in part, during subsequent
accounting periods.
The Company completed a tender offer for Micronics, Inc. during the
second quarter of 1998. In addition to managing the growing business of the
Company and its previous acquisitions, the Company will be required to
integrate and manage the business of Micronics with that of the Company.
Furthermore, Micronics is primarily a manufacturer of computer motherboards,
a line of products that the Company has not previously offered for sale.
The Company faces significant challenges in terms of manufacturing,
engineering, sales, marketing, and logistics with respect to integrating the
products and business of Micronics with similar functions of the Company.
There can be no assurance that the Company will be able to successfully
integrate the operations of Micronics. If the Company fails to successfully
integrate Micronics into the operations of the Company there will likely be
a material adverse impact on the operating results of the Company. Even if
the integration is successfully achieved, there can be no assurance that the
cost of such integration will not materially and adversely effect the
Company's operating results.
In the fourth quarter of 1998, the Company intends to commence
manufacturing and shipping its first finished consumer electronics product,
Rio, an internet music player. Also during the fourth quarter of 1998, the
Company intends to commence manufacturing and shipping the HomeFree line of
wireless home networking products. These products will pose new design,
manufacturing and customer support issues to the Company and there can be no
assurance that the Company can successfully meet these challenges or satisfy
customer demand for the products. There can also be no assurance that the
cost associated with of meeting such challenges and satisfying demand will
not have a material adverse impact on the Company's operating results in
future periods.
The Company's future operating results will depend in large measure on
its success in implementing operating, manufacturing and financial
procedures and controls, improving communication and coordination among the
different operating functions, integrating certain functions such as sales,
procurement and operations, strengthening management information and
telecommunications systems, and continuing to hire additional qualified
personnel in all areas. Moreover, the Company has completed the first
implementation phase of a new enterprise resource planning (ERP) system in
order to better manage the increasing complexity of its international multi-
product business. This system also supports the Company's efforts to avert
potential Year 2000 issues with its previous management information system.
There can be no assurance that the Company will be able to manage these
activities and implement these additional systems, procedures and controls
successfully, and any failure to do so could have a material adverse effect
upon the Company's short-term and long-term operating results.
Short Product Life Cycles; Dependence on New Products
The market for the Company's products is characterized by frequent new
product introductions and rapid product obsolescence. These factors
typically result in short product life cycles, frequently ranging from six
to twelve months. The Company must develop and introduce new products in a
timely manner that compete effectively on the basis of price and performance
and that address customer needs and meet customer requirements. To do this,
the Company must continually monitor industry trends and make difficult
choices regarding the selection of new technologies and features to
incorporate into its new products, as well as the timing of the introduction
of such new products, all of which may impair the orders for or the prices
of the Company's existing products. The success of new product introductions
depends on various factors, some of which are outside the Company's direct
control. Such factors may include: selection of new products; selection of
controller or memory chip architectures; implementation of the appropriate
standards or protocols; timely completion and introduction of new product
designs; trade-offs between the time of first customer shipment and the
optimization of software for speed, stability and compatibility; development
of supporting content by independent software application vendors;
development and production of collateral product literature; prompt delivery
to OEM accounts of prototypes; support of OEM prototypes; ability to rapidly
ramp manufacturing volumes; and coordination of advertising, press
relations, channel promotion and VAR evaluation programs. For example,
selection of the appropriate standards and protocols will be a key factor in
determining the future success of the Company's new home networking and
internet music player products.
In the current transition of mainstream PC graphics subsystem
architectures from 2D graphics and the PCI bus to 3D graphics and the
accelerated graphics port (AGP), which began in 1997 and is expected to
continue through 1998, controller and memory chip selection and the timely
introduction of new products have been and will continue to be critical
factors. The Company saw the effects of the PCI-to-AGP graphics bus
transition and the SGRAM-to-SDRAM memory transition in the second and third
quarters of 1998, which resulted in significant price reductions for the
Company's remaining PCI-based and SGRAM-based graphics inventory and the
inventory of such products in the distribution channel. As a result, the
net sales and gross margins of the Company were materially and adversely
affected by declining prices for the PCI-based and SGRAM-based products and
there were significant price protection claims associated with such price
declines. In addition, in the current transition from the widely accepted
V.34 modem protocol (33.6Kbps) through the new higher speed proprietary
K56flex and x2 protocols (56Kbps) to the new international standard V.90
protocol (56Kbps), the chip selection to implement and deploy such standards
and the industry alliances to convert such support into revenue and market
share have been and will continue to be critical factors. There can be no
assurance that the Company will select the proper chips to implement and
support its efforts in the various markets or that the Company will execute
its strategy in a timely manner during this transition period.
Each new product cycle presents new opportunities for current or
prospective competitors of the Company to gain a product advantage or
increase their market share. If the Company does not successfully introduce
new products within a given product cycle, the Company's sales will be
adversely affected for that cycle and possibly for subsequent cycles. Any
such failure could also impair the Company's brand name and ability to
command retail shelf space and OEM design wins in future periods. Moreover,
because of the short product life cycles coupled with the long lead times
for procuring many of the components used in the Company's products, the
Company may not be able, in a timely manner, or at all, to reduce its
component procurement commitments, software license commitments, production
rates or inventory levels in response to unexpected delays in product
launch, shortfalls in sales, technological obsolescence or declines in
prices or, conversely, to increase production in response to unexpected
increases in demand, particularly if such demand increases are in a new
product or new technology area where component supply may be hard to secure.
Therefore, changes in actual or expected demand could result in excess
inventory, inventory write downs, price protection and gross margin
compression or, conversely, in lost sales and revenue compression due to
product or component unavailability. 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 the Company and in the
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,
the falling demand for, and the excess supply of, Monster 3D II and
competitive entertainment 3D 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 resulting price protection for this class of
product in the third quarter of 1998. The Company estimates and accrues for
potential inventory write-offs and price protection charges. There can be
no assurance 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 the Company's
operating results in the second and third quarters of 1998 was material and
adverse. Any similar occurrence in the future could have a material effect
on operating results in such future operating periods.
New Operating Systems
The PC industry has been characterized by significant operating system
changes, such as the introduction of Windows 95 in 1995 and Windows NT 4.0
in 1996, and the introduction of significant new operating system
components, such as Microsoft's Direct X and ActiveX for Windows 95. During
the second quarter of 1998 Microsoft introduced Windows 98. In
anticipation of the release of Windows 98 a significant portion of new
computer purchasers delayed purchase of a new system until after the release
of Windows 98. The effects of this consumer resistance were compounded by
the delay and uncertainty of the release due to legal challenges.
Additionally, further purchases were delayed to ensure that the new
operating system would be compatible with older applications and would
operate at least as reliably as Windows 95. The Company believes that this
forward shift in time of a significant number of computer purchasers had an
adverse impact on the revenues of the Company in the second quarter of 1998.
In addition, while new operating systems can provide new market
opportunities, such as the growing market for graphical user interface (GUI)
accelerators that occurred with the introduction of Windows 3.0 and the
growth in the PC games market with the introduction of Windows 95, new
operating systems and operating system components also place a significant
research and development burden on the Company. New drivers, applications
and user interfaces must be developed for new operating systems and
operating system components in order to maintain net sales levels and
customer satisfaction. Perhaps more significantly, such drivers,
applications and interfaces customarily are ported to the recently shipped
portion of the Company's installed base. This effort involves a substantial
investment in software engineering, compatibility testing and customer
technical support with only limited near-term incremental revenue return
since these driver updates are usually provided via electronic distribution
at no cost to the Company's installed customer base. In addition, the
installation of this software may result in technical support calls, thereby
generating expenses that do not have offsetting revenue. Moreover, during
the introductory period of a major new operating system release such as
Windows 95 or Windows 98, such installed base support may reduce the
research and development and customer technical support resources available
for launching new products. For example, after substantial investment in
porting the Company's software, graphics accelerator and modem products to
Windows 95, the Company was at year-end 1996 still developing for final
release improved, accelerated Windows 95 drivers for the Viper Pro Video
series of accelerator add-in cards. While this product line did not at that
time represent a revenue opportunity for the Company, the Company
nevertheless believed that it was important to make the significant software
development investment represented by this effort in order to maintain
relations with its installed customer base and its reputation for reliable
on-going product support. Furthermore, new operating systems for which the
Company prospectively develops driver support may not be successful, or the
drivers themselves may not be successful or accepted by customers, and a
reasonable financial return on the corollary research and development
investment may never be achieved.
Dependence on Third Party Software Developers
The Company's business strategy includes developing relationships with
major independent software application vendors that serve the 3D graphics
and 3D audio markets, including the 3D computer games market and the
professional 3D graphics applications market. The Company believes that the
availability of a sufficient number of high quality, commercially successful
entertainment 3D software titles will be a significant factor in the sale of
multimedia hardware to the PC-based interactive 3D entertainment market.
The Company also believes that compelling professional 3D graphics
applications developed for PCs or ported from traditional workstations, such
as those supplied by Silicon Graphics and Sun Microsystems, to PCs based on
advanced Intel microprocessors and the Microsoft NT operating system will be
significant factors in the sale of 3D graphics hardware to the PC-based NT
workstation market. The Company depends on independent software application
developers and publishers to create, produce and market software
entertainment titles and professional graphics applications that will
operate with the Company's 3D products, such as Monster entertainment 3D and
Fire GL professional 3D series of graphics accelerators. Only a limited
number of software developers are capable of creating high quality
professional 3D and entertainment 3D software. Competition for these
resources is intense and is expected to increase. There can be no assurance
that the Company will be able to attract the number and quality of software
developers and publishers necessary to develop a sufficient number of high
quality, commercially successful software titles and applications that are
compatible with the Company's 3D products.
Further, in the case of the Company's entertainment 3D products, there
can be no assurance that third parties will publish a substantial number of
entertainment 3D software titles or, if entertainment 3D software titles are
available, that they will be of high quality or that they will achieve
market acceptance. The development and marketing of game titles that do not
fully demonstrate the technical capabilities of the Company's entertainment
3D products could create the impression that the Company's products offer
less compelling performance over competing 3D games platforms, such as TV
games console platforms. This may slow or stop any migration from the
current widespread use of TV games consoles to the use of computer games on
PCs, or the enhancement of PCs to operate such games. Further, because the
Company has no control over the content of the entertainment titles produced
by software developers and publishers, the entertainment 3D software titles
developed may represent only a limited number of game categories and are
likely to be of varying quality.
Semiconductor or Software Defects
Product components may contain undetected errors or "bugs" when first
supplied to the Company that, despite testing by the Company, are discovered
only after certain of the Company's products have been installed and used by
customers. There can be no assurance that errors will not be found in the
Company's products due to errors in such products' components, or that any
such errors will not impair the market acceptance of these products or
require significant product recalls. Problems encountered by customers or
product recalls could materially adversely affect the Company's business,
financial condition and results of operations. Further, the Company
continues to upgrade the firmware, software drivers and software utilities
that are incorporated into or included with its hardware products. The
Company's software products, and its hardware products incorporating such
software, are extremely complex due to a number of factors including the
products' advanced functionality, the diverse operating environments in
which the products may be deployed, the need for interoperability, and the
multiple versions of such products that must be supported for diverse
operating platforms, languages and standards. These products may contain
undetected errors or failures when first introduced or as new versions are
released. The Company generally provides a five-year warranty for its
products and, in general, the Company's return policies permit return within
thirty days after receipt of products that do not meet product
specifications. There can be no assurance that, despite testing by the
Company, by its suppliers and by current or potential customers, errors will
not be found in new products after commencement of commercial shipments,
resulting in loss of or delay in market acceptance or product acceptance or
in warranty returns. Such loss or delay would likely have a material
adverse effect on the Company's business, financial condition and results of
operations.
Additionally, new versions or upgrades to operating systems or
independent software vendor titles or applications may require upgrades to
the Company's software products to maintain compatibility with these new
versions or upgrades. There can be no assurance that the Company will be
successful in developing new versions or enhancements to its software or
that the Company will not experience delays in the upgrade of its software
products. In the event that the Company experiences delays or is unable to
maintain compatibility with operating systems and independent software
vendor titles or applications, the Company's business, financial condition
and results of operations could be materially adversely affected.
Market Anticipation of New Products, New Technologies or Lower Prices
Since the environment in which the Company operates is characterized by
rapid new product and technology introductions and generally declining
prices for existing products, the Company's customers may from time to time
postpone purchases in anticipation of such new product introductions or
lower prices. If such anticipated changes are viewed as significant by the
market, such as the introduction of a new operating system or microprocessor
architecture, then this may have the effect of temporarily slowing overall
market demand and negatively impacting the Company's operating results. For
example, the substantial pre-release publicity surrounding the release of
Windows 95 may have contributed to a slowing of the consumer PC market in
the summer of 1995. Moreover, a similar reaction occurred in the modem
market as a result of the announcements of modems based on 56 Kbps
technology, which became available in 1997, and in the overall PC market in
anticipation of Intel Corporation's transition to MMX-based microprocessors
during 1997. Additionally, the substantial publicity by Intel Corporation
for its MMX technology may have confused and slowed the market for add-in
multimedia accelerators, such as those sold by the Company, during the first
half of 1997. Similarly, Microsoft's launch of Windows 98 combined with the
uncertainties surrounding such a launch was a factor in slower PC sales in
the second quarter of 1998. These effects may continue into future periods
for these or similar events. Other anticipated new product releases that may
influence future market growth or the timing of such growth include Intel's
release of its Pentium II CPU and the associated chipsets supporting the 2x
AGP and 4x AGP architectures, Intel's release of its "Merced" workstation
CPU slated for first customer shipment in 1999, and the release of
Microsoft's Windows 2000.
The potential negative impact on the Company's operating results as a
result of customer decisions to postpone purchases in favor of new and
"publicized" technology can be further magnified if products or components
based on such new technology are not available in a timely manner or in
sufficient supply to meet the demand caused by the market's shift to the new
technology from an older technology. For example, the Company believes that
the PC market may have slowed in early 1997 in part as customers waited for
the availability of Intel's new MMX-enabled Pentium CPUs. Further, the
Company's operating results could be adversely affected if the Company makes
poor selections of chip architectures or chip suppliers to pursue 3D
graphics, AGP or 56Kbps modem market opportunities and, as a result, is
unable to achieve market acceptance of its new products or is unable to
secure a sufficient supply of such components.
If the Company or any of its competitors were to announce a product that
the market viewed as having more desirable features or pricing than the
Company's existing products, demand for the Company's existing products
could be curtailed, even though the new product is not yet available. For
example, the Company's next-generation sixteen-megabyte SDRAM-based graphics
accelerators have a memory cost component roughly equivalent to eight-
megabyte SGRAM-based graphics accelerators. Market anticipation of new
product releases such as these, as well as similar competitive releases,
reduced demand for the Company's SGRAM based graphics products and
materially and adversely affected the Company's operating results for the
second and third quarters of 1998. Similar results may occur during the
fourth quarter of 1998. Similarly, if the Company's customers anticipate
that the Company may reduce its prices in the near term, they might postpone
their purchases until such price reductions are effected, reducing the
Company's near-term shipments and revenue. In general, market anticipation
of new products, new technologies or lower prices, although potentially
positive in the longer term, can negatively impact the Company's operating
results in the short term.
Component Shortages; Reliance on Sole or Limited Source Suppliers
The Company is dependent on sole or limited source suppliers for certain
key components used in its products, particularly chipsets and software that
provide graphics, digital video, DVD, television (TV), sound or other
multimedia functions, random access memory (including DRAM, RDRAM, SDRAM,
SGRAM and flash) chips, and speakerphone/modem and fax/modem chipsets.
Although the price and availability of many semiconductor components
improved during 1997 and 1998, these components are periodically in short
supply and on allocation by semiconductor manufacturers. For example, it is
expected that the Company may experience constraints in the supply of high-
performance SGRAMs, flash memory and high-performance 3D graphics chips for
the foreseeable future. There can be no assurances that the Company can
obtain adequate supplies of such components, or that such shortages or the
costs of these components will not adversely affect future operating
results. The Company's dependence on sole or limited source suppliers, and
the risks associated with any delay or shortfall in supply, can be
exacerbated by the short life cycles that characterize multimedia and
communications ASIC chipsets and the Company's products in general. Although
the Company maintains ongoing efforts to obtain required supplies of
components, including working closely with vendors and qualifying
alternative components for inclusion in the Company's products, component
shortages continue to exist from time to time, and there can be no
assurances that the Company can continue to obtain adequate supplies or
obtain such supplies at their historical or competitive cost levels.
Conversely, in its attempt to counter actual or perceived component
shortages, the Company may over purchase certain components or pay
unnecessary expediting or other surcharges, resulting in excess inventory or
inventory at higher than normal costs and reducing the Company's liquidity,
or in the event of unexpected inventory obsolescence or a decline in the
market value of such inventory, causing inventory write-offs or sell-offs
that adversely affect the Company's gross margin and profitability. Such a
condition existed in the first quarter of 1998, and the Company's perception
of component shortages caused the Company to over purchase components and
pay surcharges for components that subsequently declined in value in the
second and third quarters of 1998. In addition, such inventory sell-offs by
the Company or its competitors could trigger channel price protection
charges, further reducing the Company's gross margins and profitability,
such as occurred with the Monster 3D II product line in the third quarter of
1998.
As noted above, supply and demand conditions for semiconductor components
are unpredictable and may change from time to time. During periods of
oversupply, prices are likely to fall and certain vendors of such
semiconductor chips may liquidate their inventories in a rapid manner. If
such semiconductor vendors are suppliers to the Company's competitors, then
such actions could enable competitors of the Company to enjoy a cost
advantage vis-a-vis the Company, and any resulting price reduction for such
competitors' products could force the Company to reduce its prices, thereby
depressing the Company's net sales and gross margins in one or more
operating periods.
During periods of component oversupply and associated price deflation,
customers of the Company, particularly those comprising channels that do not
receive price protection from the Company, may seek to draw down the
inventory that they hold since such inventory likely would bear a price
deflation risk. As a consequence, the Company may see its orders, unit
shipments or average selling prices depressed from time to time during such
price-deflation and inventory-reduction periods; this occurred during the
second quarter of 1998, which adversely affected net sales and gross margin
during such period, and this may occur again in future periods.
When the PC or PC peripherals markets emerge from a period of oversupply,
such as that experienced in the second quarter of 1997, certain
manufacturers, distributors and resellers may be unprepared for a possible
rapid increase in market demand. Accordingly, the Company may not have
sufficient inventory, scheduled component purchase orders or available
manufacturing capacity to meet any rapid increase in market demand, thereby
missing orders and revenue opportunities, causing customer dissatisfaction
and losing market share. The Company experienced such a situation in the
second half of 1997 and in the first half of 1998 as the Company experienced
a shortage of various components, restricting the Company's ability to
manufacture certain products in sufficient quantities or in a linear fashion
to meet market demand. For certain products, the Company continued to
experience such restrictions in the third quarter of 1998. In addition, the
Company believes that in the near term the Company will continue to be
subjected to restricted supply and increasing prices on certain
semiconductor components including certain graphics controllers and
memories. The inability of the Company to obtain product components at
their historical or planned cost levels, resulting in the Company being
forced to pay higher prices to achieve timely delivery, would directly
affect the cost of the Company's products and could materially and adversely
affect the Company's gross margin. There can be no assurance that the
Company will be able to obtain adequate supplies of components or that such
shortages or the costs of these components will not adversely impact the
Company's future operating results. Conversely, there can be no assurance
that the Company will not see the value of its inventory depreciate if
components in a shortage condition emerge from that condition and experience
a significant oversupply condition. For example, this situation occurred
during the second and third quarters of 1998 with certain graphics chips
that support only SGRAM memory, and in the third quarter of 1998 with
components associated with the Company's Monster 3D II product line.
Dependence on Subcontractors
The Company relies on independent surface mount technology ("SMT")
subcontractors to manufacture, assemble or test the Company's board level
products, as well as its first "finished" consumer electronics product,
Rio, an internet music player. The Company typically procures its
components, assembly and test services and assembled products through
purchase orders and does not have specific volume purchase agreements with
each of its subcontractors. Most of the Company's subcontractors could
cease supplying the services, products or components at any time with
limited or no penalty. In the event that it becomes necessary for the
Company to replace a key subcontractor, the Company could incur significant
manufacturing set-up costs and delays. There can be no assurance that the
Company would be able to find suitable replacement subcontractors. The
Company's emphasis on maintaining low inventory 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. The Company's ability
to respond to greater than anticipated market demand may be constrained by
the availability of SMT or finished product subcontracting services.
Further, various of the Company's subcontractors are located in
international locations that, while offering low labor costs, may present
heightened process control, quality control, political, infrastructure,
transportation, tariff, regulatory, legal, import, export, economic or
supply chain management risks.
Dependence on Graphics and Multimedia Accelerator Market
Sales of graphics and video accelerator subsystems accounted for greater
than 65% and 79% of the Company's net sales in the third quarter of 1998 and
1997, respectively. Although the Company has introduced audio subsystems,
has entered the PC modem and communications and home networking markets, and
has announced its intention to enter into the consumer electronics market
with its Rio Internet music player, graphics and video accelerator
subsystems are expected to continue to account for a majority of the
Company's 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 the Company's sales and
operating results.
Migration to Personal Computer Motherboards
The Company's graphics and multimedia accelerator subsystems are
individual products that function within personal computers to provide
additional multimedia functionality. Historically, as a given functionality
becomes technologically stable and widely accepted by personal computer
users, the cost of providing such functionality is typically reduced by
means of large scale integration into semiconductor chips, which can be
subsequently incorporated onto personal computer motherboards. The Company
expects that such migration will not occur in a substantial way with 3D
graphics or Intel's accelerated graphics port (AGP) in the near term,
although the Company recognizes that such migration could occur with respect
to the functionality provided by some of the Company's current products.
While the Company believes that a market will continue to exist for add-in
subsystems that provide advanced or multiple functions and offer flexibility
in systems configuration, such as 3D graphics, 3D audio and communications,
there can be no assurance that the incorporation of new multimedia functions
onto personal computer motherboards or into CPU microprocessors, such as
under Intel's MMX, Whitney or AGP technologies, will not adversely affect
the future market for the Company's products. In large part, the
continuation of a robust market for add-in graphics and video subsystems may
depend on the timing and market acceptance of 3D graphics and digital video
MPEG-2 acceleration. This, in turn, may depend on the availability of
compelling 3D and MPEG-2 content, including games and entertainment,
broadcast digital video, PC video phones, desktop video conferencing, and
digital video, audio and 3D VRML graphics on the Internet. Similarly, the
robustness of the communications market may depend largely on the widespread
adoption of 56Kbps and digital subscriber line (xDSL) technologies in both
client-side modems attached to the PC and server-side modems provided by
Internet Service Providers and telephone network central offices. The timing
of major xDSL technology introductions and the market acceptance of these
new technologies and standards are largely out of the control of the
Company.
The Company believes that a large portion of the growth in the sales of
personal computers will be in sealed systems which contain all functionality
on the motherboard and are not able to be upgraded in the manner most
current personal computers can be upgraded. These sealed computers would
contain a systems board that would include CPU, system memory, graphics,
audio, and modem functionality on a single board. The Company recently
acquired Micronics for the purpose of obtaining technical and marketing
expertise and brand acceptance in CPU motherboard design and to develop
integrated multimedia system board products. However, there can be no
assurance that a significant market will exist for low-cost fixed system
boards or that the acquisition of Micronics will enable the Company to
successfully compete in such an emerging market or in the current
motherboard market.
Risks Associated with Industry Consolidation
The Company pursues a strategy of "silicon agility" which entails
continuous evaluation of outside sources of graphics, modem, home
networking, and audio chipsets. This strategy depends on a number of
competitive suppliers of each of these products in order to ensure that the
Company is offering leading edge technology in each product line at prices
with which the Company can compete with competitors who design their own
chipsets. In the recent past there have been instances of chipset suppliers
acquiring their own add-in card manufacturing, marketing and distribution
(for example, Evans & Sutherland Corp's purchase of Accel Graphics or 3Dlabs
Inc. acquisition of Dynamic Pictures Inc.). While these acquisitions in and
of themselves are not material to the operations of the Company, any
increase in the number of vertical integration acquisitions may restrict the
choices of chipset suppliers available to the Company and thereby reduce the
likelihood that the Company will have access to leading edge technology at
prices which would allow the Company to compete with vertically integrated
competitors such as ATI Technologies Inc., Matrox Graphics Inc. and Creative
Technologies, Inc.
Competition
The market for the Company's products is highly competitive. The Company
competes directly against a large number of suppliers of graphics and
multimedia accelerator products for the PC such as Matrox Graphics Inc., STB
Systems Inc., Creative Technologies Inc. and ATI Technologies Inc., and
indirectly against PC systems OEMs to the extent that they manufacture their
own add-in subsystems or incorporate on PC motherboards the functionality
provided by the Company's products. In certain markets where the Company is
a relatively new entrant, such as modems, sound cards, and consumer
electronics Internet music players, the Company may face dominant
competitors including 3Com (modems), Creative Technologies, Inc. (sound
cards) and Sony Corp. (consumer electronic music players). In addition, the
Company's markets are expected to become increasingly competitive as
multimedia functions continue to converge and companies that previously
supplied products providing distinct functions (for example, companies today
primarily in the sound, modem, CPU or motherboard markets) emerge as
competitors across broader or more integrated product categories.
In addition, manufacturers of chipsets or other components used in the
Company's products could become future competitors of the Company to the
extent that such manufacturers elect to integrate forward into the add-in
subsystem or value-added software market (for example, the acquisition of
Accel Graphics by Evans & Sutherland), or as such multimedia chipset
manufacturers provide increasingly higher quality and more sophisticated
software to their chipset customers, including subsystem suppliers
competitive to the Company. Also, certain of the Company's current and
potential competitors have significantly greater market presence, name
recognition and financial and technical resources relative to the Company,
and many have long-standing market positions and established brand names in
their respective markets. In addition, certain of the Company's current and
potential competitors also have a competitive cost advantage as a result of
being located in areas that impose significantly lower taxes than the United
States or offer a substantially lower cost of labor or provide governmental
subsidies, such as research and development and training funds. Many of the
Company's current and potential competitors also design and manufacture
their own graphics acceleration, video, sound, fax/modem or other multimedia
processing chipsets. While the Company believes that its semiconductor
vendor flexibility enables it to select, within certain limits, from among
the most advanced and price competitive chipsets available on the open
market, the captive semiconductor operations of certain of the Company's
current and potential competitors could provide them with significant
advantages, including greater control over semiconductor architecture and
technology, component design, component performance, systems and software
design, time to market, availability and cost.
The Company also believes that the strategy of certain of its current and
potential competitors is to compete largely on the basis of price, which may
result in significant price competition and lead to lower margins for the
Company's products or otherwise adversely affect the market for the
Company's products. To the extent that semiconductor availability is
relatively robust and software drivers and reference hardware designs from
multimedia chipset manufacturers are of high quality and sophistication,
then competitors who sell such reference designs and compete largely on
price with little value-added engineering may have a competitive cost or
expense advantage relative to the Company. There can be no assurance that
the Company will be able to continue to compete successfully in its current
and future markets, or will be able to compete successfully against current
and new competitors, as the Company's technology, markets and products
continue to evolve.
Distribution Risks
The Company sells its products through a network of domestic and
international distributors, and directly to major retailers/mass merchants,
VARs and OEM customers. The Company's future success is dependent on the
continued viability and financial stability of its customer base. The
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 World Wide Web. The loss of, or reduction in,
sales to certain of the Company's key customers as a result of changing
market conditions, competition, or customer credit problems could have a
material adverse effect on the Company's operating results. Likewise,
changes in distribution channel patterns, such as increased commerce on 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 the Company in ways not yet known. Moreover, additions to or
changes in the types of products the Company sells, such as the introduction
of professional-grade products or the migration toward more communications-
centric products, such as home networking may require specialized value-
added reseller channels, relations with which the Company has only begun to
establish.
Inventory levels of the Company's products in the two-tier distribution
channels used by the Company ("Channel Inventory Levels") generally are
maintained in a range of one to three 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, when demand is slower, sales are lower and products are
abundant, then Channel Inventory Levels tend toward the high end of the
months-of-supply range. Frequently, in such situations, the Company
attempts to ensure that distributors devote their working capital, sales and
logistics resources to the Company's products to a greater degree than to
those of competitors. Similarly, the Company's 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
are more likely to occur and, should they occur, are more likely to be
severe. Further, in such an event, high Channel Inventory Levels may result
in substantial price protection charges. Such price protection charges have
the effect of reducing net sales and gross profit. Consequently, the
Company, in taking steps to bring its Channel Inventory Levels down to a
more desirable level, may cause a shortfall in net sales during one or more
accounting periods. This was the case in the third quarter of 1998 as the
company reduced channel inventory levels as part of its new short-cycle
inventory model. While this expected to reduce the Company's exposure to
future charges for price protection and excess inventory, it materially and
adversely affected revenues for the third quarter. Such efforts to reduce
channel inventory might also result in price protection charges as prices
are decreased, having an adverse impact on operating results. While the
Company believes that its Channel Inventory Levels for many of its products
are appropriate at this time, there are certain products which have a
Channel Inventory Level that is higher than desirable, specifically its
Monster 3D II product line. The Company accrues for potential price
protection charges on unsold channel inventory. However, there can be no
assurance that any estimates, reserves or accruals will be sufficient or
that any future price reductions will not have a material adverse effect on
operating results, including during the fourth quarter of 1998.
Product Returns; Price Protection
The Company frequently grants limited rights to customers to return
certain unsold inventories of the Company's products in exchange for new
purchases ("Stock Rotation"), as well as price protection on unsold
inventory. Moreover, certain of the Company's retail customers will readily
accept returned products from their own retail customers, and these returned
products are, in turn, returned to the Company for credit. The Company
estimates returns and accrues for potential price protection on unsold
channel inventory. The Company experienced significant price protection
charges due to the transition from PCI to AGP-based graphics accelerators
and from SGRAM to SDRAM-based graphics accelerators during the second and
third quarters of 1998. Moreover, the Company experienced significant price
and revenue erosion and associated price protection on its Monster 3D II
product line in the third quarter of 1998 as demand for that class of
product declined in the third quarter of 1998, and market prices also
declined significantly. The Company may be faced with further significant
price protection charges as the Company and its competitors move to reduce
channel inventory levels of current products, such as the Monster 3D II as
new product introductions are made. However, there can be no assurance that
any estimates, reserves or accruals will be sufficient or that any future
returns or price reductions will not have a material adverse effect on
operating results, including through the mechanisms of Stock Rotation or
price protection, particularly in light of the rapid product obsolescence
which often occurs during product transitions. The short product life cycles
of the Company's products, the evolving markets for new multimedia and
connectivity technologies such as the new 56 Kbps modem and 3D graphics
technologies, and the difficulty in predicting future sales through the
distribution channels to the final end customer all increase the risk that
new product introductions, price reductions by the Company or its
competitors, or other factors affecting the personal computer and add-in
subsystems industry could result in significant and unforeseen product
returns, with such returns creating a material adverse effect on the
Company's financial performance. In addition, there can be no assurance
that new product introductions by competitors or other market factors, such
as the integration of graphics and video acceleration or modem connectivity
by OEMs onto system motherboards, will not require the Company to reduce
prices in a manner or at a time that gives rise to significant price
protection charges and has a material adverse impact upon the Company's
gross margins.
Furthermore, the markets that the Company serves include end users who
buy from computer retail and consumer electronics mass merchant outlets to
upgrade their existing PCs. Such customers frequently decide to return
products to the retail outlets from which they earlier purchased the
product. Such returns are made for a variety of reasons, including the
customer changing his or her mind regarding his or her purchase decision,
the customer has difficulty with the installation or use of the product, the
product does not offer the features, functions, or performance that the
customer expected or the customer experiences incompatibilities between the
product and his or her existing PC hardware or software. Since many of the
products that the Company sells incorporate advanced computer technology,
the Company expects that end-user customer returns, including warranty
returns, will be a continuing negative attribute of supplying the PC
installed-base upgrade market. There can be no assurance that the Company
will be able to achieve gross margins in the PC installed-base upgrade
market that will be high enough to offset the expenses of end-user customer
returns and still generate an acceptable return on sales to the Company.
OEM Customer Risks
The Company currently has a limited number of OEM customers. While the
Company is seeking to increase its sales to OEMs, certain OEMs maintain
internal add-in subsystem design and manufacturing capabilities or have
long-standing relationships with competitors of the Company, and there can
be no assurance that the Company will be successful in its efforts to
increase its OEM sales. Moreover, developing supplier relationships with
major PC systems OEMs and installing the processes, procedures and controls
required by such OEMs can be an expensive and time-consuming process, and
there can be no assurance that the Company will achieve an acceptable
financial return on this investment. Further, to the extent that PC systems
OEM's selection criteria are weighted toward multimedia subsystem suppliers
that have their own captive SMT manufacturing operations, then the Company's
sole reliance on outside SMT subcontract manufacturers may be a negative
factor in winning such PC systems suppliers' OEM contracts.
It is expected that OEM revenue will carry a lower gross margin
percentage compared to sales to other channels due to perceived lower
expenses to support such OEM revenue and the buying power exercised by large
OEMs. Furthermore, many large OEMs require that distribution hubs be
established local to their factories to supply such factories on very short
notice. Such hubs represent a cash drain on the Company to support the
required inventory, and a product obsolescence and inventory write-off risk
as the price of such inventory may decline or reach the end of its useful
life or the design-in life at the OEM before such inventory, which may be
specific to a certain OEM, is completely consumed. The Company's
contractual relationships with Dell, Micron and Compaq regarding such hubs
may represent such product obsolescence and inventory write-off risks.
The Company's products are priced for and generally aimed at the higher
performance and higher quality segment of the market. Therefore, to the
extent that OEMs focus on low-cost solutions rather than high-performance
solutions, an increase in the proportion of the Company's sales to OEMs may
result in an increase in the proportion of the Company's revenue that is
generated by lower-selling-price and lower-gross-margin products,
particularly with respect to the Company's audio and modem products, which
could adversely affect future gross margins and operating results of the
Company.
Rapid Technological Change
The markets for the Company's products are characterized by rapidly
changing technology, evolving industry standards, frequent new product
introductions and rapid product obsolescence. For example, 3D technology is
evolving rapidly in the graphics and audio markets, memory architectures and
speeds are changing rapidly, and DVD and MPEG-2 decryption techniques and
navigation technologies are still being refined and moving from hardware-
centric to software-centric implementations. Product life cycles in the
Company's markets frequently range from six to twelve months. The Company's
success will be substantially dependent upon its ability to continue to
develop and introduce competitive products and technologies on a timely
basis with features and functionalities that meet changing customer
requirements in a cost-effective manner. Further, if the Company is
successful in the development and market introduction of new products, it
must still correctly forecast customer demand for such new products so as to
avoid either excessive unsold inventory or excessive unfilled orders related
to the products. The task of forecasting such customer demand is unusually
difficult for new products, for which there is little sales history, and for
indirect channels, where the Company's customers are not the final end
customers. Moreover, whenever the Company launches new products, it must
also successfully manage the corollary obsolescence and price erosion of
those of its older products that are impacted by such new products, as well
as any resulting price protection charges and Stock Rotations from its
distribution channels. During the second quarter of 1998, the Company
experienced large price protection charges with respect to the decline in
average selling prices of graphics accelerators due to the SGRAM to SDRAM
transition of mainstream graphics accelerators and other competitive
pressures. Due to the much lower cost of SDRAM solutions SGRAM prices fell
in competition thereby lowering manufacturing costs of graphics
accelerators. The Company, forced to meet the pricing actions of its
competitors was forced to lower prices triggering larger than normal or
expected price protection and eroding the value of some of the Company's on
hand inventory. A similar phenomenon occurred in the third quarter of 1998
relative to the Company's Monster 3D II product line.
Risks of International Sales
The Company's international sales are subject to a number of risks
generally associated with international business operations, including the
effect on demand for the Company's products in international markets as a
result of a strengthening or weakening U.S. dollar, the effect of currency
fluctuations on consolidated multinational financial results, any state-
imposed restrictions on the repatriation of funds, any import and export
duties and restrictions, certain international economic conditions, the
expenses, time and technical resources required to localize the Company's
various products and to support local languages, the logistical difficulties
of managing multinational operations and dispersed product inventory
designed or manufactured to meet specific countries' requirements, and the
delays and expenses associated with homologating the Company's
telecommunications products and securing the necessary governmental
approvals for shipment to various countries.
The Company's international sales can also be affected if inventory sold
by the Company to its international distributors and OEMs and held by them
or their customers does not sell through to final end customers, which may
impact international distributor or OEM orders in the succeeding periods.
The Company believes that it generally has less information with respect to
the inventory levels held by its international OEMs and distributors as
compared to their domestic counterparts, and that the supply chain to such
international customers is longer, and that therefore the Company generally
has less visibility on how this held inventory might affect future orders to
and sales by the Company. In the event that international OEMs or
distributors change their desired inventory levels, there can be no
assurance that the Company's net sales to such customers will not decline at
such time or in future periods, or that the Company will not incur price
protection charges with respect to such customers.
Also, during the first three quarters of 1998, sales in Asia and
Southeast Asia were below expected levels. The lack of sales in the Asian
market were primarily related to the lack of credit facilities available to
customers in those markets for the Company's products and other products
necessary for those customers to sell complete products. The Company expects
continued sluggishness in sales in Asia and Southeast Asia during the
remainder of 1998 and continuing into 1999.
Information Technology and Telecommunications Systems
The Company is currently making significant investments in establishing
systems, processes and procedures to more efficiently and effectively manage
its worldwide business and enable communications and data sharing among its
employees and various business units. This effort comprises a significant
investment of expense and capital funds, as well as a drain on management
resources, for the installation of information technology ("IT"), network
and telecommunications equipment and IT applications. As part of this
program to install IT systems throughout the Company, management has begun
installation of an enhanced enterprise-wide business management, resource
planning and decision support application. Further, in order to more
effectively manage the Company's business and avert Year 2000 issues, the
Company is implementing this new ERP application and the associated
processes and procedures and installing the associated IT equipment in order
for it to be fully operational no later than by the beginning of 1999. Such
an effort is expected to comprise a further substantial investment of
expenses and management resources by the Company.
Year 2000 Compliance
Many existing computer systems and applications, and other control
devices, use only two digits to identify a year in the date field,
without considering the impact of the upcoming change in the century. As
a result, such systems and applications could fail or create erroneous
results unless corrected so that they can process data related to the
year 2000. The Company relies on its systems, applications and devices
in operating and monitoring all major aspects of its business, including
financial systems (such as general ledger, accounts payable and payroll
modules), customer services, infrastructure, embedded computer chips,
networks and telecommunications equipment and end products. The Company
also relies, directly and indirectly, on external systems of business
enterprises such as customers, suppliers, creditors, financial
organizations, and of governmental entities, both domestic and
international, for accurate exchange of data. The Company recently
completed the first phase of a project to upgrade the computer hardware
and software it uses to operate, monitor and manage its business on a day
to day basis. At the end of the third quarter, the Company's operations
were converted to this system on an integrated, world-wide basis. This
effort was undertaken to significantly improve the tools and information
available to manage the Company. These tools have the added benefit of
managing data with dates beyond December 31, 1999 as indicated by the
vendors. The Company continues to test such capabilities as part of its
post-implementation process. This testing is expected to be completed
during the first half of 1999. The Company's current estimate is that the
costs specifically associated with this testing and validation process
will not have a material adverse effect on the result of operations or
financial position of the Company in any given year. However, despite the
Company's efforts to address the year 2000 impact on its internal
systems, the Company has not fully identified such impact or whether it
can resolve it without disruption of its business and without incurring
significant expense. In addition, even if the internal systems of the
Company are not materially affected by the year 2000 issue, the Company
could be affected through disruption in the operation of the enterprises
with which the Company interacts. See "-Information Technology and
Telecommunications Systems."
Capital Needs
There can be no assurance that additional capital beyond the amounts
currently forecasted by the Company will not be required or that any
required additional capital will be available on reasonable terms, if at
all, at such time or times as required by the Company. Any shortfall in
capital resources compared to the Company's level of operations or any
inability to secure additional capital as needed could impair the Company's
ability to finance inventory, accounts receivable and other operational
needs. Such capital limitations could also impair the Company's ability to
invest in research and development, improve customer service and support,
deploy information technology systems, and expand manufacturing and other
operations. Failure to keep pace with competitive requirements in any of
these areas could have a material adverse effect on the Company's business
and operating results. Moreover, any need to raise additional capital
through the issuance of equity or debt securities may result in additional
dilution to earnings per share.
Proprietary Rights
While the Company had 14 issued U.S. Patents and 20 pending U.S. Patent
Applications at September 30, 1998, it nonetheless relies primarily on a
combination of trademark, copyright and trade secret protection together
with licensing arrangements and nondisclosure and confidentiality agreements
to establish and protect its proprietary rights. There can be no assurance
that the Company's measures to protect its proprietary rights will deter or
prevent unauthorized use of the Company's technology, brand or other
proprietary or intellectual property. In addition, the laws of certain
foreign countries may not protect the Company's proprietary rights to the
same extent as do the laws of the United States or the EC. As is typical in
its industry, the Company from time to time is subject to legal claims
asserting that the Company has violated the proprietary rights of third
parties. In the event that a third party was to sustain a valid claim
against the Company, and any required licenses were not available on
commercially reasonable terms, the Company's operating results could be
materially and adversely affected. Litigation, which could result in
substantial cost to and diversion of the resources of the Company, may also
be necessary to enforce proprietary rights of the Company or to defend the
Company against claimed infringement of the proprietary rights of others.
Stock Price Volatility
The trading price of the Company's Common Stock has been subject to
significant fluctuations to date, and could be subject to wide fluctuations
in the future in response to quarter-to-quarter variations in operating
results, announcements of technological innovations, new products or
significant OEM systems design wins by the Company or its competitors,
general conditions in the markets for the Company's products or the computer
industry, the price and availability of purchased components, general
financial market conditions, market conditions for PC or semiconductor
stocks, changes in earnings estimates by analysts, or other events or
factors. In this regard, the Company does not endorse and accepts no
responsibility for the estimates or recommendations issued by stock research
analysts from time to time. In addition, the public stock markets in
general, and technology stocks in particular, have experienced extreme price
and trading volume volatility. This volatility has significantly affected
the market prices of securities of many high technology companies for
reasons frequently unrelated to the operating performance of the specific
companies. These broad market fluctuations may adversely affect the market
price of the Company's Common Stock.
Dependence on Key Personnel
The Company's future success will depend to a significant extent upon the
efforts and abilities of its senior management and professional, technical,
sales and marketing personnel. The competition for such personnel is
intense, particularly in the San Jose, California area ("Silicon Valley").
There can be no assurance that the Company will be successful in retaining
its existing key personnel or in attracting and retaining the additional key
personnel that it requires. The loss of services of one or more of its key
personnel or the inability to add or replace key personnel could have a
material adverse effect on the Company. The salary, performance bonus and
stock option packages necessary to recruit or retain key personnel,
particularly in Silicon Valley, may significantly increase the Company's
expense levels or result in dilution to the Company's earnings per share.
The Company does not carry "key person" life insurance on any of its
employees.
Legal Matters
The Company has been named as a defendant in several putative class
action lawsuits which 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. Certain executive officers
and directors of the Company are also named as defendants. The plaintiffs
purport to represent a class of all persons who purchased the Company's
Common Stock between October 18, 1995 and June 20, 1996 (the "Class
Period"). The complaints allege claims under the federal securities laws
and California law. The plaintiffs allege that the Company and the other
defendants made various material misrepresentations and omissions during the
Class Period. The complaints do not specify the amount of damages sought.
The Company believes that it has good defenses to the claims alleged in the
lawsuits and will defend itself vigorously against these actions. These
cases are in the early stages and no trial date has been set. The ultimate
outcome of these actions cannot be presently determined. Accordingly, no
provision for any liability or loss that may result from adjudication or
settlement thereof has been made in the accompanying consolidated financial
statements.
The Company has been named as a defendant in a lawsuit filed on October
9, 1998 in the United States District Court for the Central District of
California. Plaintiffs are 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 alleges 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 does not comply
with the requirements of the AHRA. On October 16, 1998 a hearing was held
and the Court issued a Temporary Restraining Order preventing the Company
from manufacturing or distributing the Rio product for a period of ten days.
On October 26, 1998 a hearing was held to determine if a Preliminary
Injunction should issue to further restrain the Company until the conclusion
of the suit. The court denied the motion and refused to restrain the
Company from manufacturing and distributing the Rio product. The RIAA has
filed a notice that it intends to appeal the Court's ruling to the United
States Court of Appeals for the Ninth Circuit. No schedule has been set for
any briefing or other action on the appeal. No provision for any liability
or loss that may result from adjudication or settlement of this action has
been made in the accompanying consolidated financial statements.
The Company is also party to other claims and pending legal proceedings
that generally involve employment and patent issues. These cases are, in
the opinion of management, ordinary and routine matters incidental to the
normal business conducted by the Company. In the opinion of management, the
ultimate disposition of such proceedings will not have a materially adverse
effect on the Company's consolidated financial position or future results of
operations.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company has been named as a defendant in several putative class
action lawsuits which 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. Certain executive officers and
directors of the Company are also named as defendants. The plaintiffs
purport to represent a class of all persons who purchased the Company's
Common Stock between October 18, 1995 and June 20, 1996 (the "Class
Period"). The complaints allege claims under the federal securities laws
and California law. The plaintiffs allege that the Company and the other
defendants made various material misrepresentations and omissions during the
Class Period. The complaints do not specify the amount of damages sought.
The Company believes that it has good defenses to the claims alleged in the
lawsuits and will defend itself vigorously against these actions. These
cases are in the early stages and no trial date has been set. The ultimate
outcome of these actions cannot be presently determined. Accordingly, no
provision for any liability or loss that may result from adjudication or
settlement thereof has been made in the accompanying consolidated financial
statements.
The Company has been named as a defendant in a lawsuit filed on October
9, 1998 in the United States District Court for the Central District of
California. Plaintiffs are 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 alleges 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 does not comply
with the requirements of the AHRA. On October 16, 1998 a hearing was held
and the Court issued a Temporary Restraining Order preventing the Company
from manufacturing or distributing the Rio product for a period of ten days.
On October 26, 1998 a hearing was held to determine if a Preliminary
Injunction should issue to further restrain the Company until the conclusion
of the suit. The court denied the motion and refused to restrain the
Company from manufacturing and distributing the Rio product. The RIAA has
filed a notice that it intends to appeal the Court's ruling to the United
States Court of Appeals for the Ninth Circuit. No schedule has been set for
any briefing or other action on the appeal. No provision for any liability
or loss that may result from adjudication or settlement of this action has
been made in the accompanying consolidated financial statements.
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. In the opinion of management, the
ultimate disposition of such proceedings will not have a materially adverse
effect on the Company's consolidated financial position or future results of
operations.
ITEM 2. CHANGES IN SECURITIES
Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
Pursuant to Rule 14a-4(c)(1) under the Securities and Exchange Act
of 1934, the proxies of management would be allowed to use their
discretionary voting authority with respect to any non-Rule 14a-8
stockholder proposal raised at the Company's annual meeting of
stockholders, without any discussion of the matter in the proxy
statement, unless the stockholder has notified the Company of such
proposal at least 45 days prior to the month and day on which the Company
mailed its prior year's proxy statement. Since the Company mailed its
proxy statement for the 1998 annual meeting of stockholders on April 17,
1998, the deadline for receipt of any such stockholder proposal for the
1999 annual meeting of stockholders is March 3, 1999.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
A. Exhibit
Exhibit # Description of Document
Not Applicable
B. Reports on Form 8-K
In connection with the acquisition of Micronics, the Company
filed a report on Form 8K on July 14, 1998, as amended on September
14, 1998, describing the merger and providing financial statements
and pro forma financial information relating thereto.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DIAMOND MULTIMEDIA SYSTEMS, INC.
Date: November 16, 1998 /s/ William J. Schroeder
-------------------------
William J. Schroeder
President and Chief Executive Officer
Date: November 16, 1998 /s/ James M. Walker
--------------------
James M. Walker
Senior Vice President and
Chief Financial Officer
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
- - ------ -----------
27.1 Financial Data Schedule