================================================================================
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 1998
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
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 Identification No.)
incorporation or organization)
2880 JUNCTION AVENUE, SAN JOSE, CALIFORNIA 95134
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (408) 325-7000
Securities registered pursuant to Section 12(b) of the Act:
Title of each class: None
Name of each exchange on which registered: None
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $.001 PAR VALUE
(TITLE OF CLASS)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
As of March 1, 1999, 31,971,548 shares of common stock were outstanding. The
aggregate market value of the voting shares (based on the closing price reported
by the Nasdaq Stock Market on March 1, 1999) of Diamond Multimedia Systems,
Inc., held by nonaffiliates was $229,795,001. For purposes of this disclosure,
shares of common stock held by persons who own 5% or more of the outstanding
common stock and shares of common stock held by each officer and director have
been excluded in that such persons may be deemed to be "affiliates" as that term
is defined under the Rules and Regulations of the Act. This determination of
affiliate status is not necessarily conclusive.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement to be filed prior to April 30, 1999,
pursuant to Regulation 14A of the Securities and Exchange Act of 1934 are
incorporated by reference into Part III of this Form 10-K.
PART I
ITEM 1. BUSINESS
The discussion and analysis below contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934. 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" in this report.
Diamond Profile
Diamond Multimedia Systems, Inc. ("Diamond" or the "Company")
designs, develops, manufactures and markets multimedia and connectivity
products for personal computers ("PCs"). The Company is a leading
supplier of graphics and multimedia accelerator subsystems for PCs, and
is expanding its position as a leader in multimedia and connectivity
products for the digital home, enabling consumers to create, access and
experience compelling new media content from their desktops and through
the Internet. Diamond products include the Rio line of Internet music
players, the Stealth and Viper series of video accelerators, the Monster
series of gaming accelerators, the Fire series of NT workstation 3D
graphics accelerators, the Supra series of modems, and the HomeFree
line of home networking products. Headquartered in San Jose, CA, Diamond
has sales, marketing and technical facilities in several locations
including Vancouver (Wash.), Singapore, Sydney, Hong Kong, Seoul, Tokyo,
Starnberg (Germany), Saarbruecken (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, mass
merchants, VARs and OEMs worldwide. In addition, the Company sells its
products through e-commerce websites, including its own on-line store at
www.diamondmm.com, mail order catalog organizations and national
reseller organizations. The Company has been engaged in expanding its
product offerings and distribution channels through internal development
and acquisitions. In September 1995, the Company acquired Supra
Corporation ("Supra"), which designs, develops, manufactures and markets
modem products. In November 1995, the Company acquired SPEA Software AG
("Spea"), a German corporation that designs, develops and markets
professional 3D graphics accelerators for Windows NT workstations. In
June 1998, the Company acquired Micronics Computers, Inc. ("Micronics"),
which designs, develops and markets graphics and audio accelerators and
motherboards. In September 1998, the Company acquired DigitalCast, a
Korean corporation that designed and developed the Company's initial
Internet appliance sold under the Rio brand name.
The Company was incorporated in Delaware in December 1994 as the
successor to Diamond Multimedia Systems, Inc., a California corporation
incorporated in May 1973 ("Diamond CA"). For additional information
regarding the Reorganization, refer to Note 1 in the Notes to
Consolidated Financial Statements. In April 1995, the Company completed
an initial public offering of 7,475,000 shares of common stock raising
net proceeds of approximately $117 million. Additionally, in November
1995, the Company completed a follow-on public offering of common stock
which raised net proceeds of approximately $94 million. Refer to
Liquidity and Capital Resources in Item 7 for discussion of the use of
these proceeds.
Strategy
Diamond's strategy is to identify emerging markets and customers
needs, to use its technological expertise to quickly provide integrated,
easy to install and use, high-performance multimedia and connectivity
solutions for the PC platform, and to use its worldwide channels to
achieve broad distribution and support of its products. The Company's
objectives for the coming year include: capitalizing on new technologies
such as digital audio over the Internet, digital video over the
Internet, 3D graphics for NT workstations, broadband modems and home
networking; expanding business with large OEMs, international retailers
and VARs; expanding international sales; increasing penetration of the
market for audio accelerators and digital audio players; launching a
major Internet audio portal and audio content aggregation website; and
strengthening its information technology systems infrastructure to
provide better customer delivery and support at lower operating costs.
Through selective acquisitions, Diamond has been able to add to its
technical expertise and product offerings while further improving its
distribution channels and market presence both domestically and
internationally. In September 1995, Diamond purchased Supra, giving
Diamond added expertise in PC communications and presence in the retail
markets. In November 1995, the Company purchased Spea. The addition of
Spea provided Diamond with a key strategic position in Europe, helping
to expand Diamond's presence internationally as a leading supplier of
visual and connectivity systems for the PC, and added professional 3D
graphics and Open GL software driver expertise to the Company. In
November 1997, the Company acquired Binar Graphics, Inc. ("Binar"),
adding graphics engineering capability and certain proprietary
intellectual property in graphics acceleration. In June 1998, the
Company acquired Micronics, adding selected retail channels in Northern
Europe and the U.K. and a design, test and quality assurance team for
integrated system boards. In September 1998, the company acquired
DigitalCast, adding digital audio Internet appliances to the Company's
product line.
A key element of Diamond's strategy is to remain silicon agile,
allowing the Company to incorporate the best semiconductor integrated
circuits available on the open market. By sourcing chips from a variety
of semiconductor developers, the Company believes it is better able to
keep pace with the current rapid advances in multimedia and connectivity
technology and bring best-of-breed products to market. The Company
currently has research and development efforts underway using chipsets
from a variety of companies, including but not limited to Aureal,
Conexant, IBM, Intel, Lucent, Motorola, NVidia, S3, and Texas
Instruments. There can be no assurance, however, that these efforts will
result in actual new product introductions.
With the increasing incorporation of multimedia, connectivity and
visual computing capabilities into the PC platform, Diamond's objectives
are to expand international sales, serve new OEM and channel assembly
customers such as VARs and system integrators, and capitalize on new
multimedia and connectivity product categories such as entertainment 3D
animation and NT workstation 3D graphics, digital ADSL (G.Lite) and
cable modems, digital video and digital audio media players, an Internet
music portal and Internet music players, and home networking products.
Products
The Company operates in a single industry segment encompassing the
design, development, manufacture, marketing and support of computer
subsystems and appliances that accelerate multimedia on the PC platform,
connect the PC platform to the Internet or play back digital media
content. All the Company's products share certain characteristics such
as common customers, common sales channels and common Company
infrastructure requirements.
Video Accelerators. The Company's mainstream video/graphics
accelerators enhance system performance by increasing the speed at which
video and graphics are displayed while also improving resolution, image
stability and color depth. The Company's Stealth and Viper series of
multimedia accelerators offer mainstream 2D and 3D graphics acceleration
with full-screen, full-motion digital video playback. Some products also
offer optional TV-In, TV-Out, and/or TV tuner capabilities.
Gaming Accelerators. The Company offers two types of 3D gaming
accelerators. The Company's Monster 3D line of graphics accelerators is
aimed at the interactive entertainment 3D market and accelerates a large
and growing number of 3D games on the PC. The Company's Monster Sound
line of 3D audio accelerators is aimed at the same interactive gaming
market, but provides positional 3D audio capabilities to the PC.
NT Workstation Graphics. The Company's Fire GL series of graphics
accelerators is aimed at the professional workstation 3D market for such
applications as content creation, 3D animation, website creation, Open
GL acceleration and CAD on the Intel Architecture/Windows NT platform.
System Boards. The Company is developing a limited line of integrated
multimedia system boards incorporating based motherboard technology
obtained in the Micronics acquisition, combined with the Company's
existing graphics and audio technology. The Company intends to introduce
the first of these products during the first half of 1999.
Communications. Under the Supra brand name, the Company markets a
line of dial-up analog fax/modems. The Company has also launched an
effort to bring broadband digital modems to market, including a line of
DSL and cable modems.
Home Networking. The Company shipped its first wireless home
networking products in November 1998 and its first phoneline based home
network products in January 1999. HomeFree Wireless allows customers to
connect two or more computers within a home or small office using radio
frequency transmission. HomeFree Phoneline allows consumers to connect
two or more computers within a home using their existing telephone
wires.
Internet Appliances. In November 1998, the Company shipped its
first Internet appliance. The Rio is a playback device for near-CD
quality music that has been downloaded from the Internet to a PC's hard
drive in compressed form. Software is also provided to allow the
compression and transfer of music from personal CD collections to a PC
storage device for subsequent playback using the Rio. The Rio is flash
memory based and battery powered allowing the portable play back of
computer based music using the MP3 format.
Internet Audio Portal. In January 1999, the Company launched
RioPort.com, a portal for information about and access to legal music
and other downloads from the Internet as well as to provide information
on Internet based audio content. Current plans call for the expansion of
RioPort.com to include revenue generation through advertising banners,
links to other commercial audio web sites and the aggregation of
Internet-based music content.
See "Certain Factors That May Affect Future Performance - Short
Product Life Cycles; Dependence on New Products," "-New Operating
Systems," "-Market Anticipation of New Products, New Technologies or
Lower Prices," "-Migration to Personal Computer Motherboards" and "-
Rapid Technological Change".
Sales, Distribution and Customer Support
The Company sells its products through independent domestic and
international distributors and directly to larger computer retailers,
mass merchants, system integrators, VAR and OEMs. In addition, the
Company sells its products in the United States through e-commerce
websites, including its own on-line store at www.diamondmm.com, mail-
order catalog organizations and national reseller organizations. The
Company is currently seeking to expand its penetration of e-commerce,
consumer electronics retail/mass merchant channels, and NRO/VAR
channels, including programs to address the large and growing channel
assembly business, and to increase its sales to large PC systems
manufacturers. See "Certain Factors That May Affect Future
Performance -OEM Customer Risks," "-Product Returns; Price
Protection" and "-Distribution Risks."
The Company has built a customer service and technical support
organization focused on providing value to the Company's customers
beyond the purchase of the Company's products. In this regard, the
Company provides on-line customer service and technical support to
customers via email and an artificial intelligence "wizard" accessible
through the Company's website, as well as through facsimile and direct
telephonic communication. The Company supports the online community
through its presence on the World Wide Web, where technical support,
frequently asked questions and a searchable knowledge base can be found.
More than 80% of the Company's customer support contacts are currently
handled by automated systems.
The Company continues to undertake significant efforts to expand its
sales channels through international penetration. The Company has
expanded its sales and support organizations in Europe, including
Eastern Europe, Latin America, and Asia-Pacific, including Japan. The
requirements of these regions are, however, substantially different from
one another and from the North American market. Any inability of the
Company to successfully penetrate these new channels or to manage them
on a profitable basis could have a material adverse effect on operating
results. See "Certain Factors That May Affect Future Performance - Risks
of International Sales."
Products sold to OEM customers in bulk-packaged format typically
consist of board-level hardware accompanied by software drivers,
multimedia utility applications and a manual, all frequently implemented
on a CD-ROM to reduce cost and package size. Products sold to computer
retailers and mass merchants typically consist of the hardware, the
software and the manuals that are incorporated into the OEM products
and, in many cases, additional bundled hardware and software components
and installation aids, all in packaging appropriate for consumer sale.
Distributors and NROs purchase products both packaged for resale to
retail outlets, typically for the installed-base upgrade market, and
bulk packaged for resale to systems integrators and VARs for
incorporation into original-sale PC systems.
Research and Development
The Company believes that continued investment in research and
development will be critical to the ability of the Company to continue
to introduce, on a timely basis and at competitive prices, new and
enhanced products incorporating the latest technology and addressing
emerging market needs. The Company's research and development staff
consisted of 205 employees at December 31, 1998. The Company's software
engineers are engaged in ongoing development of software and firmware
drivers to enhance the performance of graphics, video and audio
accelerators, analog and digital modems, and various PC/Internet
appliances, as well as upgrades to the Company's proprietary software
utility applications. The Company's engineers are also engaged in the
development of new products such as multimedia system boards, that will
offer various combinations of 3D graphics, digital video, 3D sound, and
other emerging PC and Internet multimedia functions, as well as in the
development of RioPort.com. Research and development expenses were
$29,923,000, $24,886,000, and $18,824,000 in the years ended December
31, 1998, 1997, and 1996, respectively. See "Certain Factors That May
Affect Future Performance - Short Product Life Cycles; Dependence on New
Products," "-Market Anticipation of New Products, New Technologies or
Lower Prices," "-New Operating Systems" and "-Rapid Technological
Change".
The Company also endeavors to work closely with third parties that
are strategic to the Company's business. The Company works with
suppliers of 3D graphics, digital video, audio, modem, and other
multimedia chipsets in an effort to select the appropriate advanced
components for the Company's new PC multimedia products. The Company
seeks to develop in a timely manner the software required to incorporate
the chipsets into the Company's products, and the Company's products
into the evolving architecture and capabilities of the PC and the
Internet. The Company also works with leading personal computer
hardware, operating system and software applications suppliers in order
to stay abreast of emerging opportunities and new standards in the
market. There can be no assurance that the Company's development efforts
will be successful, or that the Company will be able to introduce
competitive new products into the marketplace in a timely manner.
Manufacturing
The Company uses an international network of independent printed
circuit board assembly subcontractors, principally located in Asia, to
assemble and test the boards that are the principal hardware component
of the Company's products. The Company generally procures boards on a
turnkey basis from it subcontract manufacturing suppliers, but may
procure architectural components and consign these to its subcontractors
for assembly and board-level testing. The Company performs quality
assurance on its products, but subcontracts production level product
testing. In 1997, the Company started the use of full turnkey
offshore subcontractors. In 1998, the proportion of products
manufactured by full turnkey subcontractors increased, and the Company
expects to further expand the portion of its procurement, manufacturing
and test that is conducted in this manner. The Company's expectation is
that after the first quarter of 1999, the only products not being
procured primarily on a turnkey basis will be new products in their
launch phase.
The Company packages the assembled boards its receives from its
subcontractors with software, manuals and additional hardware
components, placing such materials in retail packaging for the
retail/mass merchant channel and in bulk packaging for the OEM and
system integrator channels. While the Company uses several electronics
assembly subcontractors to minimize the risk of business interruption,
there can be no assurance that a problem will not arise with one or more
of these suppliers that could adversely affect operating results. See
"Certain Factors That May Affect Future Performance - Component
Shortages; Reliance on Sole or Limited Source Suppliers," and "-Rapid
Technological Change".
Proprietary Rights
While the Company had 14 issued U.S. Patents and 23 pending U.S.
Patent Applications at December 31, 1998, it 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. See "Certain
Factors That May Affect Future Performance - Proprietary Rights."
Competition
The market for the Company's products is highly competitive. The
Company competes directly against a large number of suppliers of PC add-
in visual and audio subsystems, Internet appliances, home networking
products, and PC communications products, as well as indirectly against
OEMs and semiconductor suppliers to the extent they manufacture their
own add-in subsystems or incorporate on their personal computer
motherboards the functionality provided by the Company's add-in or add-
on products. In addition, the Company's markets are expected to become
increasingly competitive as multimedia and connectivity functions
continue to converge, the price of the average PC drops and companies
that previously supplied products providing distinct functions (for
example, companies in the graphics, video, sound, modem and networking
markets) emerge as competitors across broader product categories and in
the emerging category of PC and Internet appliances. See "Certain
Factors That May Affect Future Performance - Competition."
Employees
As of December 31, 1998, the Company had 890 full-time employees, 210
of whom were engaged in manufacturing (including test, quality
assurance, procurement and materials functions), 205 in development
engineering, 210 in marketing, field applications support and sales, 140
in technical support and customer service, and 125 in finance, IT and
administration. The Company's employees are not represented by any
collective bargaining agreements and the Company has never experienced a
work stoppage. The Company believes that its employee relations are
good.
EXECUTIVE OFFICERS
The following table sets forth the names, ages and office of all of the
executive officers of the Company:
Name Age Office Held
- ------------------------- ----- ---------------------------------------
William J. Schroeder 54 President and Chief Executive Officer,
Director
James M. Walker 50 Senior Vice President and Chief
Financial Officer
Franz Fichtner 46 President, Diamond Europe
C. Scott Holt 57 Senior Vice President, Worldwide Sales
Hyung Hwe Huh 46 Senior Vice President and Chief
Technical Officer
Wade Meyercord 58 Senior Vice President, Management
Systems and Continuous Improvement
Dennis D. Praske 51 Senior Vice President, Worldwide
Operations
There are no family relationships between any of the executive
officers and directors.
Mr. Schroeder has served as President and Chief Executive Officer of
the Company and as a member of the Board of Directors since May 1994,
and as Chairman of the Board since May 1998. Mr. Schroeder was employed
by Conner Peripherals, Inc. ("Conner") from 1986 to 1994, initially as
President and, from 1989, as Vice Chairman of the Board of Directors. He
was also President of Conner's New Products Group from 1989 to 1990,
President of Archive Corporation (a Conner subsidiary) from January 1993
to November 1993, and CEO of Arcada Software, Inc. (a Conner subsidiary)
from November 1993 to May 1994. Mr. Schroeder is also a director of
Xircom, Inc., Sync Research, Inc., and CNF Transportation, Inc.
Mr. Walker joined the Company in December 1996 as Senior Vice
President and Chief Financial Officer. Mr. Walker was formerly employed
by Global Village Communication as Vice President and Chief Financial
Officer from 1993 to 1996. Previously, Mr. Walker served as Chief
Operating Officer for Fujitsu Computer Products from 1990 to 1993 and as
Vice President of Finance for its parent company, Fujitsu America, from
1987 to 1990. Mr. Walker is Chairman of the Board of Alara, Inc., a
privately-held medical imaging technology firm.
Mr. Fichtner joined the Company in October 1997 as President, Diamond
Europe. Mr. Fichtner was formerly employed by 3Com from 1990 to 1997,
most recently as President, Europe, Middle East and Africa from 1995 to
1997, as Managing Director 3Com Gmbh, Central Europe from 1991 to 1994,
and as Technical Manager for the Central European Sales Region from 1990
to 1991.
Mr. Holt joined the Company in January 1995 as Senior Vice President,
Worldwide Sales. From 1986 to 1994, Mr. Holt was employed by Conner,
most recently as Executive Vice President, Corporate Accounts and
Americas Sales. Mr. Holt was the Executive Vice President of Sales and
Marketing at Conner from 1986 until 1992.
Mr. Huh joined the Company in 1983 as Engineering Manager and was
promoted to Chief Engineer in 1985, to Vice President of Engineering in
1989, and to the position of Senior Vice President and Chief Technical
Officer in 1994. Mr. Huh was a member of the Board of Directors of the
Company from 1985 to January 1995.
Mr. Meyercord joined the Company in November 1997 as Senior Vice
President, Management Systems and Continuous Improvement, and
transitioned to Senior Vice President, E-Commerce and Quality Assurance
during the fourth quarter of 1998. Mr. Meyercord was formerly employed
as President of the consulting firm, Meyercord and Associates, from 1987
to 1997. Mr. Meyercord is Chairman of the Board of California Micro
Devices and a director of ADFlex Solutions.
Mr. Praske joined the Company in October 1995 as Vice President of
Worldwide Operations and was promoted to Senior Vice President in April
1997. Prior to joining the Company, Mr. Praske was the Vice President
of Worldwide Materials for the Storage Division of International
Business Machines (IBM). Previously, Mr. Praske served as Vice
President of Commodity Management at Conner Peripherals, Inc. from 1988
to 1993.
ITEM 2. Properties
The Company's headquarters facility in San Jose, CA consists of one
building of approximately 80,000 square feet which is leased by the
Company through January 2002, and another building of approximately
30,000 square feet which is leased by the Company through January 2003.
Additionally, the Company has an 83,000 square foot facility in
Milpitas, California, primarily for manufacturing and logistics which is
leased through January 2001. The Company's facilities in Vancouver,
Washington and Albany, Oregon consist of three buildings comprising
approximately 22,100, 21,000 and 35,800 square feet, respectively. The
22,100 square foot facility expires in November 2000 and the 21,000
square foot facility lease expires June 1999 and is currently subleased
through the remaining term. The Albany property was purchased in 1991.
The Company's facilities in Europe encompass a 26,000 square foot
building in Winnersh, U.K. with a lease commencement date of May 1996.
The lease is a fifteen-year term with 3, 5 and 10-year cancellation
options. Facilities in Germany consist of a 22,000 square foot building
in Starnberg which is leased through 2001. The Company also leases sales
or technical support offices in the metropolitan areas of Tokyo, Japan;
Paris, France; Seoul, South Korea, Sydney, Australia; Ontario, Canada
and Singapore. The Company also leases sales or software development
offices in Atlanta, Georgia; Dallas and Houston Texas; Chicago,
Illinois; Huntsville, Alabama; Miami and Coral Springs, Florida; San
Francisco, CA and Red Bank, New Jersey and Raleigh, North Carolina. The
Company recently opened a logistics center in Kowloon Bay, Hong Kong to
support offshore turnkey operations and sales in Asia. The facility is
owned and run by a third party service provider on a service contract
that expires in September 2000. The Company believes that its existing
facilities are adequate to meet its facilities requirements for the near
term.
ITEM 3. 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 law 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. No trial date has been
set for any of these actions. 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 4. Submission of Matters to a Vote of Security Holders
None.
ITEM 5. Market For The Registrant's Common Equity And Related
Stockholder Matters
==========================================================================
Closing price:
High Low
---------- ----------
Fiscal Year 1998:
First quarter.................................... $ 16-1/4 $ 8-7/8
Second quarter................................... $ 15-1/4 $ 5-7/8
Third quarter.................................... $ 7 $ 3-1/2
Fourth quarter................................... $ 7-3/16 $ 3-1/32
Fiscal Year 1997:
March 31, ....................................... $ 17 $ 9-3/4
June 30, ........................................ $ 9-1/8 $ 6-5/8
September 30, ................................... $ 11-3/4 $ 6-15/16
December 31, .................................... $ 13-13/16 $ 8-13/16
The Company's common stock trades on the Nasdaq Stock Market under
the symbol "DIMD". The price range per share reflected in the above
table is the highest and lowest closing prices for the Company's stock
as reported by the Nasdaq, during each quarter. The Company's present
policy is to retain its earnings to finance future growth. The Company
has never declared or paid cash dividends and has no present intention
to declare or pay cash dividends. At December 31, 1998 there were
approximately 570 stockholders of record including nominees and brokers
holding street name accounts.
ITEM 6. SELECTED FINANCIAL DATA
Years Ended December 31,
--------------------------------------- ---------
1998 1997 1996 1995 1994
--------- --------- --------- --------- ---------
(in thousands, except per share data)
Net sales................................ $608,581 $443,281 $598,050 $467,635 $203,297
Gross profit............................. 66,687 55,795 112,766 108,350 57,983
Write-off of in-process technology....... -- -- -- 76,710 --
Income (loss) from operations............ (66,418) (67,719) 22,708 (19,273) 33,137
Net income (loss)........................ (39,489) (45,605) 16,337 (41,347) 20,116
Net income (loss) per share:
Basic.............................. ($1.13) ($1.33) $0.48 ($1.55) $1.62
Diluted............................ ($1.13) ($1.33) $0.46 ($1.55) $1.12
Total assets............................. 306,910 337,554 332,438 351,729 120,854
Current portion of long-term debt........ 45,516 36,455 18,068 18,077 82,664
Long-term debt, net of current portion... 1,550 1,873 2,730 11,705 34,167
Mandatorily redeemable preferred stock... -- -- -- -- 29,174
Total shareholders' equity (deficit)..... 146,370 180,521 224,295 208,610 (55,949)
SELECTED QUARTERLY FINANCIAL DATA
First Second Third Fourth
Quarter Quarter Quarter Quarter
--------- --------- --------- ---------
(Unaudited & in thousands except per share data)
YEAR ENDED DECEMBER 31, 1998
Net sales................................ $186,196 $172,347 $123,200 $126,838
Gross profit............................. 41,626 20,463 383 4,216
Income (loss) from operations............ 11,132 (12,080) (31,227) (34,243)
Net income (loss)........................ $7,927 ($8,284) ($22,176) (16,983)
Net income (loss) per share:
Basic.............................. $0.23 ($0.24) ($0.63) ($0.48)
Diluted............................ $0.22 ($0.24) ($0.63) ($0.48)
YEAR ENDED DECEMBER 31, 1997
Net sales................................ $112,402 $52,982 $92,028 $185,869
Gross profit............................. 19,585 (23,118) 18,178 41,150
Income (loss) from operations............ (9,934) (63,500) (4,367) 10,082
Net income (loss)........................ ($5,951) ($44,109) ($2,553) $7,008
Net income (loss) per share:
Basic.............................. ($0.17) ($1.29) ($0.07) $0.20
Diluted............................ ($0.17) ($1.29) ($0.07) $0.20
No dividends have been declared in any of the periods presented. See
"Item 5" for a discussion of the Company's dividend history. Data for
1995 includes acquisitions of Supra and Spea completed during the year,
and data for 1998 includes the acquisitions of Micronics and DigitalCast
completed during the year, all of which were accounted for as purchase
business combinations. "See Management's Discussion and Analysis of
Financial Condition and Results of Operations".
ITEM 7. 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" and elsewhere
in this report.
The following discussion should be read in conjunction with the five-
year summary of selected financial data and 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 personal computers ("PCs"). The Company is a leading
supplier of graphics and multimedia accelerator subsystems for PCs, and
is expanding its position as a leader in multimedia and connectivity
products for the digital home, enabling consumers to create, access and
experience compelling new media content from their desktops and through
the Internet. Diamond products include the Rio line of Internet music
players, the Stealth and Viper series of video accelerators, the Monster
series of gaming accelerators, the Fire series of NT workstation 3D
graphics accelerators, the Supra series of modems, and the HomeFree
line of home networking products. Headquartered in San Jose, CA, Diamond
has sales, marketing and technical facilities in several locations
including Vancouver (Wash.), Singapore, Sydney, Hong Kong, Seoul, Tokyo,
Starnberg (Germany), Saarbruecken (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, mass
merchants, VARs and OEMs worldwide. In addition, the Company sells its
products through e-commerce websites, including its own on-line store at
www.diamondmm.com, mail order catalog organizations and national
reseller organizations. The Company has been engaged in expanding its
product offerings and distribution channels through internal development
and acquisitions. In September 1995, the Company acquired Supra
Corporation ("Supra"), which designs, develops, manufactures and markets
fax/modem products. In November 1995, the Company acquired SPEA Software
AG ("Spea"), a German corporation that designs, develops and markets
professional 3D graphics accelerators for Windows NT workstations. In
June 1998, the Company acquired Micronics Computers, Inc. ("Micronics"),
which designs, develops and markets graphics and audio accelerators and
motherboards. In September 1998, the Company acquired DigitalCast, a
Korean corporation that designed and developed the Company's initial
Internet appliance sold under the Rio brand name.
Net Sales
Net sales were $608.6 million, $443.3 million, and $598.1 million in
1998, 1997, and 1996, respectively. Net sales increased in 1998 by
$165.3 million or 37% compared to 1997, primarily due to an expanded
product line-up, including two brand new product lines released in the
latter half of the year, Rio and HomeFree, increased demand for 56K
modems, and strong first half demand for graphics accelerators. Net
sales decreased in the latter half of the year due to significant price
erosion and price protection charges for graphics accelerator cards.
Net sales decreased in 1997 by $154.8 million or 26% compared to 1996,
primarily due to significant price erosion and lower unit demand in the
Company's base business of multimedia accelerator systems and modems,
particularly during the first and second quarters of 1997 in which large
price protection charges were triggered. The demand for the Company's
products increased in the latter half of the year as new products such
as the Monster 3D and Viper series of graphics accelerator cards were
introduced and began shipping in volume. Also during the fourth quarter
of 1997, there was strong demand for the Fire GL 1000 and 4000 series of
professional 3D graphics accelerator cards, as well as the 56K modems.
Net sales increased in 1998 by 20% in North America, 86% in Europe
and 17% in other international markets (Asia and Latin America)
following 1997 declines of 27%, 12% and 42%, respectively. Net sales in
North America accounted for 54%, 62% and 62% of total net sales during
1998, 1997 and 1996, respectively. Net sales in Europe accounted for
36%, 26% and 22% of total net sales during 1998, 1997 and 1996,
respectively. Other international net sales accounted for 10%, 12% and
16% of total net sales during 1998, 1997 and 1996, respectively. The
continued increase in revenues from Europe is a result of stronger
selling efforts and relatively stronger European economies. Declines in
other international sales since 1996 resulted primarily from weaker
national economies and financial instability. Although the Company's
international sales are primarily denominated in U.S. dollars, these
sales are subject to a number of risks generally associated with
international sales, including the effect of currency fluctuations,
state-imposed restrictions on the repatriation of funds, import and
export restrictions, and the logistical difficulties of managing
international operations.
Gross Profit
Gross margin (gross profit as a percentage of sales) was 11.0%,
12.6%, and 18.9% in 1998, 1997, and 1996, respectively. Gross margin
declined to 11.0% of net sales in 1998 from 12.6% of net sales in 1997
primarily due to the absorption in the third and fourth quarters of 1998
of large price protection credits granted to customers as a result of
sales price decreases, inventory write-down charges to record inventory
at lower-of-cost or market value, sales rebate deductions, and
competitive pricing pressures across most product lines. In the third
quarter of 1998, these charges were primarily associated with
competitive pressures. In the fourth quarter of 1998, these charges
were related to the Company's announced restructuring of its graphics
accelerator business to reduce the number of chipset architectures it
would support in the future and reduce the number of models of each
supported architecture. At the same time, the Company determined to
change its strategy with respect to distribution channels by controlling
channel inventory levels and reserving against any financial benefit of
shipments into the distribution channel that exceeded four weeks of
demand. This resulted in reduced margins due to the restriction of
shipments of higher margin products compared to prior years as well as
an increase in the reserves against revenue. Gross margin declined to
12.6% of net sales in 1997 from 18.9% of net sales in 1996 particularly
due to absorbing in the second quarter of 1997 large price protection
credits granted to customers as a result of sales price decreases,
inventory write-down charges to record inventory at lower-of-cost or
market value, sales rebate deductions, and competitive pricing pressures
across most product lines. Further, gross margin was adversely impacted
by significantly lower sales volume levels over which indirect
manufacturing costs could be absorbed.
Research and Development
Research and development expenses, primarily consisting of personnel
expenses, were $29.9 million, $24.9 million, and $18.8 million in 1998,
1997, and 1996, respectively, constituting 4.9%, 5.6%, and 3.1% of net
sales, respectively. The increases in research and development expenses
for 1998 compared to 1997 and 1997 compared to 1996 were primarily due
to continued increases in headcount (from 150 at the end of 1996 to 196
at the end of 1997 to 205 at the end of 1998), and increases in
occupancy costs, material costs and outside service costs These
headcount related and other expenses were associated with new product
development on an increasing number of graphics architectures, and in
1998, investment in the development of new product lines such Rio,
HomeFree and DSL modems. For 1998, the decrease in expense as a percent
of net sales was primarily due to more normalized revenue levels
compared with 1997. For 1997, the increase in expense as a percentage of
net sales was primarily due to a significant decline in net sales during
1997. The Company anticipates that its research and development expenses
will continue to increase in absolute dollars and may increase as a
percentage of sales. The Company has not capitalized any software
development costs to date.
Selling, General and Administrative
Selling, general and administrative expenses were $97.7 million,
$85.7 million, and $66.2 million in 1998, 1997, and 1996, respectively,
and constituted 16.1%, 19.3%, and 11.1% of net sales, respectively. The
increase in actual dollar terms in 1998 compared to 1997 reflects higher
marketing expenses, higher depreciation expenses, higher facility and
related office expenses, increased personnel related expenses associated
with the Company's acquisitions of Micronics and DigitalCast, higher
outside professional fees related, in part, to certain ongoing
litigation and tax consulting services, and higher travel expenses
associated with selling and administrative efforts. Expenses relating to
channel incentive programs declined in 1998. The increase in expenses in
1997 compared to 1996 reflected higher sales and marketing promotional
programs, higher depreciation expense and increased personnel-related
expenses associated with increased sales and marketing efforts.
Selling, general and administrative costs decreased as a percentage
of net sales in 1998 due to the significant increase in net sales as
compared to 1997. Selling, general and administrative costs increased
significantly as a percentage of net sales in 1997 as compared to 1996
due to higher selling and marketing costs and also due to the large
decline in net sales that occurred in 1997 as compared to 1996.
The Company anticipates that its selling, general and administrative
expenses will increase slightly in absolute dollars as the Company
continues efforts at penetrating certain sales channels and regions, and
continues to strengthen management information and telecommunications
systems to support its existing and acquired businesses and the
anticipated growth in the scope of its operations.
Amortization of Intangible Assets
The Company wrote-off $9.9 million of intangible assets in the second
quarter of 1997 to reflect an impairment in the value of goodwill
and existing technology associated with the acquisitions of Supra and
Spea. The anticipated cash flows related to those products indicated
that the recoverability of those assets was not reasonably assured. The
Company also incurred amortization expense of $2.6 million and $3.0
million in 1998 and 1997, respectively, related to amortization of
purchased technology and goodwill from the Supra, Spea, Micronics and
DigitalCast acquisitions. As a result of the Company's acquisitions, the
Company expects to incur aggregate amortization expense of approximately
$4.4 million annually for 1999, 2000, and 2001, $4.2 million in 2002,
$3.7 million in 2003, $3.6 million in 2004 and $1.8 million in 2005.
Interest Income and Expense
Interest income was $2.9 million, $2.9 million and $3.6 million
for 1998, 1997 and 1996, respectively, and resulted from cash available
for investment. Interest income declined from 1996 to 1997 due to lower
available cash balances available for investing. Interest income was
flat from 1997 to 1998. Interest expense was $2.7 million, $1.2 million
and $1.7 million for 1998, 1997 and 1996, respectively. Interest expense
declined from 1996 to 1997 due to lower use of available credit lines.
Interest expense increased from 1997 to 1998 due to an increase in the use
of available credit lines.
Other Income
The Company recorded other expense of $2.7 million during 1998,
primarily due to the sale of equity interest in SP3D, which was acquired
as a result of its acquisition of Spea in 1995. Additional significant
components of other expense included foreign currency translation losses
and loss on the final settlement of a lawsuit. The Company recorded
other income of $0.9 million in 1997 due primarily from a gain on final
settlement of a lawsuit. The Company recorded other income in 1996 of
$1.2 million primarily related to Value Added Tax (VAT) refunds and
foreign currency translation gains.
Provision (Benefit) for Income Taxes
The Company's effective tax rate was (30.0%) for 1998 excluding the
impact of the recognition of a foreign tax benefit resulting from a tax
audit which has been closed. The Company's effective tax rate was
(35.4%) in 1997 excluding the impact of the write-off of $9.9 million of
intangibles during 1997 which were not deductible for income tax
purposes. For 1996, the effective tax rate was 37.0%. For 1996 through
1998, differences from the statutory rates consisted principally of the
effect of state income taxes, foreign income taxes, federal tax-exempt
interest income, the amortization of intangibles, and the research and
development tax credit.
Deferred Tax Assets
The Company was not profitable in 1998 and has shown a cumulative
loss over the past three years. However, significant new business
contracts have been awarded to the company over the past several
months. These sales contracts are with established industry leaders and
cover a broad spectrum of the Company's products including
core graphics accelerators, Window NT workstation graphics accelerators,
modems and home networking. Based upon this incremental business and
related margins, management has determined that no valuation allowance is
necessary since it is more likely than not the deferred tax asset will
be realized.
Net operating loss carryforwards will expire as follows (in thousands);
---------------------------------------------
Federal State Foreign Total
---------------------------------------------
2002 -- $5,405 -- $5,405
2003 -- $10,544 -- $10,544
2007 -- -- $2,863 $2,863
2018 $86,161 -- -- $85,161
No expiration -- -- $24,899 $24,899
---------- ---------- ---------- ------------
Total $86,161 $15,949 $27,762 $129,872
========== ========== ========== ============
LIQUIDITY AND CAPITAL RESOURCES
During 1998, the Company used $32.4 million in cash from operating
activities primarily due to a net loss of $39.5 million, an increase in
deferred income taxes of $35.4 million, a reduction of trade payables
and other accrued liabilities of $24.2 million, and the non-cash effects
of the provision of excess and obsolete inventories of $9.1 million.
These were partially offset by a decrease in inventories of $43.1
million, a decrease in income tax receivable of $15.5 million, a
decrease in trade accounts receivable of $7.2 million, the establishment
of a new deferred income liability of $7.2 million, and depreciation and
amortization expenses of $9.2 million. Net cash used in investing
activities was $37.1 million and consisted primarily of the acquisitions
of Micronics and DigitalCast totaling $23.9 million net of cash
acquired, $18.3 million for purchases of property and equipment, the
majority of which was related to the installation of the Company's new
global enterprise wide computer system, the purchase of $1.8 million in
short-term investments, and an equity investment in a technology partner
in the amount of $1.2 million. This was partially offset by the sale of
a building owned by Micronics, and proceeds from the sale of the
Company's equity interest in a joint venture. Net cash provided by
financing activities was $8.2 million and was comprised primarily of
proceeds from term loans and revolving credit facilities of $89.0
million and proceeds from the issuance of common stock under the
Company's stock option and stock purchase programs of $5.3 million. This
was partially offset by payments and maturities of term loans and
revolving credit facilities of $79.9 million, and the investment of $5.5
million in restricted certificates of deposit as collateral for certain
lines of credit.
At December 31, 1998, the Company had two domestic bank credit
facilities: a $30 million line of credit permitting borrowings at the
bank's reference rate or a formula Libor based rate and a $15 million
line of credit permitting borrowings at the bank reference rate or a
formula Libor based rate. Borrowings under these lines at December 31,
1998 were $25 million and $10 million, respectively. The Company was in
violation of certain covenants with regard to the credit facilities at
December 31, 1998. Further, the agreements for these lines of credit
expire in May 1999 and January 1999, respectively. In January 1999, the
Company closed a new $50 million domestic bank credit facility and the
previous facilities were paid in full and closed.
Additionally, the Company has credit facilities under foreign lines
of credit. At December 31, 1998, the Company's Japanese subsidiary had a
Yen line of credit entitling it to borrow up to approximately
$3.0 million. The line of credit is collateralized by a stand-by letter
of credit from the Company and accrues interest at the bank's variable
rate. Borrowings were $2.7 million under this facility at December 31,
1998. At December 31, 1998, the Company's Spea subsidiary had a 5
million DeustcheMark line of credit (approximately $3.0 million at
December 31, 1998) with a German bank. Additionally, the Company had a
foreign line of credit of 10 million DeustcheMarks (approximately $6.0
million at December 31, 1998). Of the $9.0 million available under these
lines, $5.7 million was being used as of December 31, 1998. These
agreements expired January 31, 1999. The bank has extended an open line
of credit for a total of 10 million DeustcheMarks (approximately $6.0
million at December 31, 1998).
The Company expects to spend approximately $15 million for capital
equipment in 1999, including enhancements to the enterprise-wide
business management, resource planning and decision support application
implemented in 1998.
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.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Investments and Hedging Activities" (SFAS 133) which
establishes accounting and reporting standards requiring that every
derivative instrument be recorded in the balance sheet as either an
asset or liability measured at its fair value. The statement also
requires that changes in the derivative's fair value be recognized
currently in earnings unless specific hedge accounting criteria are met.
SFAS 133 is effective for fiscal years beginning after June 15, 1999.
The Company does not expect the adoption of SFAS 133 to have a material
effect on the Company's consolidated financial statements.
Year 2000 Compliance
Many existing computer systems and applications, as well as numerous
embedded 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, applications or control devices
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 and movement of both components and products. 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. Despite the Company's efforts to address the year 2000
impact on its internal systems, it is impossible to know with certainty
the impact the year 2000 issue will have on the business and what
additional expenses may be incurred. See "-Information Technology and
Telecommunications Systems."
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. The Company is in the process of
identifying significant external agents such as service providers,
vendors, suppliers and customers and attempting to reasonably determine
their ability to manage year 2000 issues.
The total costs associated with year 2000 compliance is not expected
to be material to the company's financial position. The most significant
cost was averted by the Company's otherwise planned ERP installation.
Ongoing compliance efforts including IT systems testing and the review
of external agents will be carried out in the normal course of business.
It is not possible for the Company to determine with certainty the
impact of the year 2000 problem due to internal computer systems or
external agents. The failure to correct a material year 2000 problem or
to anticipate and mitigate a problem with an external agent could result
in an interruption in or failure of normal business activities or
operations. Such failures could materially and adversely affect the
company's results of operations, liquidity and financial condition.
Contingency plans will be developed if it appears the Company or its key
external agents will not be year 2000 compliant, and such compliance is
expected to have a material adverse impact on the Company's operations.
CERTAIN FACTORS THAT MAY AFFECT FUTURE PERFORMANCE
In addition to other information in this Form 10-K, 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, portable
audio device, 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 other resellers), system integrators, 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), and directly to end users
via e-commerce. Reliance on 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 as, and frequently within a few days of, the
customer's requested date of shipment by the Company.
Because the lead times of firm orders are typically short, the Company
does not have the ability to predict future operating results with any
certainty. 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
and 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, particularly for large OEM
customers. This has the effect of increasing 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 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 continued through 1998, controller and
memory chip selection and the timely introduction of new products were 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 net 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 net sales
for the second quarter of 1998 were lower than expected because of 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 deflation as a
result of rapid downturns in customer orders, competitors' actions or
industry price trends. This is expected to 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 in relation to expectations or in relation to the market
opportunity.
Declining Selling Prices and Other Factors Affecting Gross Margins
The Company's markets are characterized by intense ongoing competition
coupled with a past history, as well as 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 those 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 a product's life cycle and,
should customers choose to wait for the new version of a product rather
than to purchase the current version, the ability of the Company to procure
sufficient volumes of such new products to meet higher customer demand is
limited. Such a failure to meet demand for new products may 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, multimedia, communications, or networking
controller chips or bundled third-party software applications 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, as well as the effect of an oversupply of SDRAM memory in the
market. 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 revenue 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,
process development 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, telecommunications and networking
systems; establishment of a significant worldwide web and e-commerce
presence; 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 completed a tender offer for Micronics Computers, 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 affect the Company's operating results, or that the Company will
be able to make a satisfactory return on such costs.
In the fourth quarter of 1998, the Company commenced manufacturing and
shipping its first finished consumer electronics product, Rio, a portable
Internet music player. Also during the fourth quarter of 1998, the Company
commenced manufacturing and shipping the HomeFree line of wireless home
networking products. The Company commenced manufacturing and shipping the
HomeFree phoneline-based home networking products in January 1999. 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, generate customer demand for such products 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 certain areas. Moreover, the Company has completed the first
implementation phase of a new enterprise resource planning (ERP) system to
better manage the increasing complexity of its international multi-product
business. This system, along with subsequent planned implementation phases,
also supports the Company's efforts to avert potential Year 2000 issues
with its previous management information systems. 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 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 drivers and hardware 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 to meet customer
demand in a timely fashion; and coordination of advertising, press
relations, channel promotion and VAR evaluation programs with the
availability of new products. 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 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 continued 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 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 the transition
from the proprietary K56flex and x2 protocols (56Kbps) to the international
standard V.90 protocol (56Kbps), the chip selection to implement and deploy
such standard and the industry alliances to generate revenue and market
share have been critical factors. The Company currently faces similar
standards-setting issues in the areas of home networking, broadband modems
and Internet audio. There can be no assurance that the Company will select
the proper chips, software and protocols to implement and support its
efforts in developing new products or targeting new markets or that the
Company will execute its strategies in a timely manner.
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. For example, the timing and speed of
the PCI-to-AGP bus transition and the SGRAM-to-SDRAM memory transition led
to an excess inventory of PCI and SGRAM-based products at 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 excess supply of Monster 3D II and
competitive 3D gaming products in the channel during the third quarter of
1998 resulted in rapidly declining revenue and prices vis-a-vis the second
quarter of 1998, and the 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, third and fourth quarters of 1998 were
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 UNIX-based workstations, such as those supplied by Silicon
Graphics, IBM 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 the Viper and Fire GL 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 graphics and audio
platforms.
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 graphics
accelerators or 3D games platforms, such as TV games consoles. 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 vis-a-vis those available for TV
game consoles 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 rapid
pace of technology development and change in the Company's target product
categories, 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 for full credit 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,
independent software vendor titles or applications may require upgrades to
the Company's software products to maintain compatibility with such 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 new product
releases that may influence future market growth or the timing of such
growth include Intel's release of its Pentium III CPU and the associated
chipsets supporting the 2x AGP and 4x AGP architectures, Intel's release of
its "Merced" workstation CPU, and the anticipated release of Microsoft's
Windows 2000. Further, slippage in the actual volume shipment of such new
products could have the effect of prolonging any market slowdown due to the
anticipation of the new products.
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" technologies, including the Company's own new technologies,
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, in the second quarter of 1998, the Company's next-generation
SDRAM-based graphics accelerators had a memory cost component roughly half
that of 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
second quarter of 1999 as the market anticipates new 32-megabyte graphics
accelerators. 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. This factor constitutes an exceptionally difficult-to-
manage characteristic of the Company's graphics business due to the rapid
six-month product cycles that typify the current 3D graphics market.
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 softmodem chipsets and
algorithms. 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, SDRAMs and flash memory and new
technology, 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 periodically 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. Further, the Company has as an
objective to reduce the number of chip architecture suppliers with which it
works, potentially raising "single-source" supply risks. 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, third and
fourth 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 and fourth
quarters 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 and third quarters of 1998, which adversely affected net sales and
gross margin during such periods, 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 quarters of 1997 and
1998, 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 second 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. 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 newly introduced graphics controllers and random access 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 and fourth quarters
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 internal and channel inventory levels
may exacerbate the effects of any shortage that may result from the use of
sole-source subcontractors during periods of tight supply or rapid order
growth. 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 77% and 75% of the Company's net sales in 1998 and 1997, respectively.
Although the Company has introduced audio subsystems, has entered the PC
modem and home networking markets, and has entered into the PC consumer
electronics market with its Rio Internet music player, graphics and video
accelerator subsystems are expected to continue to account for 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. While 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 due to the new, rapidly changing technologies in these areas, the
Company recognizes that such migration could occur with respect to the
functionality provided by some of the Company's current products, and with
3D graphics and the AGP bus over the longer term. 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 and
connectivity 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 acceleration. This, in turn, may depend on the
availability of compelling 3D and digital video content, including games
and entertainment, broadcast digital video, PC videophones, 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 digital subscriber line (xDSL)
and cable modem technologies in both client-side modems attached to the PC
and server-side modems provided by Internet Service Providers and telephone
network central offices, and the emergence of a robust, growing home
networking market. The timing of major xDSL, cable modem and home
networking 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 may be in sealed systems which contain most
functionality on a single systems board 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 could include CPU, system
memory, graphics, audio, and connectivity 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, 3Dfx's purchase of STB Systems, or the 3Dlabs Inc. acquisition of
Dynamic Pictures Inc.). While these acquisitions in and of themselves are
not material to the operations of the Company, vertical integration
acquisitions restrict the choices of chipset suppliers available to the
Company and thereby may reduce the likelihood that the Company will have
access to leading edge technology at prices which allow the Company to
compete with vertically integrated competitors such as ATI Technologies
Inc., Matrox Graphics Inc., 3Com Corporation, 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 multimedia and
connectivity products for the PC such as Matrox Graphics Inc., 3Dfx,
Creative Technologies Inc., 3COM Corporation, 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, home networking,
sound cards, and consumer electronics Internet music players, the Company
may face dominant competitors including 3Com (home networking and modems),
Creative Technologies, Inc. (sound cards, modems and Internet music
players) 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
STB Systems by 3Dfx), or as 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, video, sound, modem, home networking, or other
multimedia and connectivity 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 lower prices and 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 worldwide 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. For example, the rapid
emergence of Internet-based e-commerce is putting substantial strain on
some of the Company's traditional channels. 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 two months of customer demand. 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 is 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 and
fourth quarters. Such efforts to reduce channel inventory might also result
in price protection charges if prices are decreased to move product out to
final consumers, 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. 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.
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 potential price protection on unsold channel
inventory. The Company accrues reserves for estimated returns, including
warranty returns, and price protection, and since the fourth quarter of
1998, reserves the gross margin associated with channel inventory levels
that exceed four weeks of demand. 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, third and fourth 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 and fourth
quarter of 1998 as demand for that class of product declined, 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
Viper V550, 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 cable or xDSL
modems 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
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 that
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 having difficulty with the installation or use of the product,
the product not offering the features, functions, or performance that the
customer expected or the customer experiencing 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 to
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
OEMs 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 functions 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, lowered 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 and fourth quarters
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.
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. While Asian
markets have begun to recover, the Company expects continued volatility and
sluggishness in sales to Asia and Southeast Asia during 1999 as well as
very slow sales to Latin America for the foreseeable future.
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
middle 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, as well as numerous
embedded 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, applications or control devices
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 and movement of both components and products. 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. Despite the Company's efforts to address the year 2000
impact on its internal systems, it is impossible to know with certainty
the impact the year 2000 issue will have on the business and what
additional expenses may be incurred. See "-Information Technology and
Telecommunications Systems."
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. The Company is in the process of
identifying significant external agents such as service providers,
vendors, suppliers and customers and attempting to reasonably determine
their ability to manage year 2000 issues.
The total costs associated with year 2000 compliance is not expected
to be material to the company's financial position. The most significant
cost was averted by the Company's otherwise planned ERP installation.
Ongoing compliance efforts including IT systems testing and the review
of external agents will be carried out in the normal course of business.
It is not possible for the Company to determine with certainty the
impact of the year 2000 problem due to internal computer systems or
external agents. The failure to correct a material year 2000 problem or
to anticipate and mitigate a problem with an external agent could result
in an interruption in or failure of normal business activities or
operations. Such failures could materially and adversely affect the
company's results of operations, liquidity and financial condition.
Contingency plans will be developed if it appears the Company or its key
external agents will not be year 2000 compliant, and such compliance is
expected to have a material adverse impact on the Company's operations.
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 23 pending U.S. Patent
Applications at December 31, 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 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. No trial date has been set for any of these actions. 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.
Quantitative and Qualitative Disclosures About Market Risk
The Company is exposed to financial market risks due primarily to
changes in interest rates. The Company does not use derivatives to alter
the interest characteristics of its investment securities or its debt
instruments. The Company has no holdings of derivative or commodity
instruments and does not conduct business in foreign currencies.
The fair value of the Company's investment portfolio or related income
would not be significantly impacted by changes in interest rates since the
investment maturities are short. The Company has limited long term debt,
principally in the form of two building mortgages, one of which has a
balloon payoff in 2001. The weighted average interest rate on the mortgages
is 8.26%. The Company's other notes payable against its lines of credit as
of December 31, 1998 carried a variable interest rate of the Libor rate
plus a margin with interest payments due monthly. The Company's new credit
line carries a variable interest rate of the prime rate plus a margin with
interest payments due monthly.
The table below presents principal amounts and related weighted average
interest rates by year for the Company's cash, cash equivalent, and short-
term investment accounts, and its debt obligations.
The table below presents principal amounts and related weighted average
interest rates by year for the Company's cash, cash equivalent, and
short-term investment accounts, and its debt obligations.
There-
1999 2000 2001 2002 2003 after Total
-------- --------- --------- --------- --------- --------- ---------
(dollars in thousands)
Assets:
Cash, cash equivalents and
short-term investments.......$36,072 $ -- $ -- $ -- $ -- $ -- $36,072
Weighted average interest rate. 4.80%
Liabilities:
Fixed rate debt................ 85 92 555 33 36 404 1,205
Variable rate debt............. 45,437 107 26 28 31 232 45,861
PART III
ITEM 10. Directors and Executive Officers of the Registrant
Information regarding Registrant's directors will be set forth under
the caption "Election of Directors" in Registrant's proxy statement for
use in connection with the Annual Meeting of Shareholders to be held in
May 1999, (the "Proxy Statement") and is incorporated herein by
reference. The Proxy Statement will be filed with the Securities and
Exchange Commission within 120 days after December 31, 1998.
Information with respect to the Registrant's executive officers is
included at the end of Part I, Item 1, of this report under the caption
"Executive Officers".
ITEM 11. Executive Compensation
Information regarding remuneration of Registrant's directors and
executive officers will be set forth under the caption "Executive
Compensation" in Registrant's Proxy Statement and is incorporated herein
by reference.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management
Information regarding security ownership of certain beneficial owners
and management will be set forth under the caption "Share Ownership of
Certain Beneficial Owners and Management" in Registrant's Proxy
Statement and is incorporated herein by reference.
ITEM 13. Certain Relationships and Related Transactions
Information regarding certain relationships and related transactions
will be set forth under the caption "Certain Transactions" in
Registrant's Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 14. Exhibits, Financial Statement Schedules
(a) 1. Financial Statements
The following Consolidated Financial Statements of Diamond Multimedia
Systems, Inc., and its subsidiaries are filed as part of this report on
Form 10-K
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 1998 and 1997
Consolidated Statements of Operations for the three years ended
December 31, 1998
Consolidated Statements of Shareholders' Equity (Deficit) for the
three years ended December 31, 1998
Consolidated Statements of Cash Flows for the three years ended
December 31, 1998
Notes to Consolidated Financial Statements
2. Consolidated Financial Statement Schedules
Schedule II-Valuation and Qualifying Accounts
Schedule I through V not listed above have been omitted because
the matter or conditions are not present or the information
required to be set forth therein is included in the Consolidated
Financial Statements hereto.
3. EXHIBITS
Exhibit
Number Exhibit Description
- ---------- --------------------------------------------------------------
3.1(1) Certificate of Incorporation.
3.2(1) Bylaws of Registrant.
4.1(1) Form of Common Stock Certificate.
10.1(1) Form of Indemnification Agreement for officers and directors.
10.2(1) Form of Indemnification Agreement with certain stockholders.
10.3(1) 1992 Stock Plan and form of Stock Option Agreement.
10.4(1) 1994 Stock Plan and form of Stock Option Agreement.
10.5(5) 1995 Employee Stock Purchase Plan and form of Subscription
Agreement.
10.6(1) 1995 Director Option Plan and form of Stock Option Agreement.
10.7(5) 1998 Stock Plan and form of Stock Option Agreement.
10.8(1) Stock Purchase Agreement by and among the Registrant, Diamond
Multimedia Systems, Inc., a California corporation, and the
investors and shareholders named therein.
10.9(1) Stock and Subordinated Notes Purchase Agreement by and among the
Registrant and the investors name therein.
10.10(1) Shareholders' Agreement by and among the Registrant and the
investors, management shareholders and shareholders named therein.
10.11(1) Registration Rights Agreement by and among the Registrant and the
investors, management shareholders and shareholders named therein.
10.12(1) Employment Agreement between the Registrant and Mr. Hyung Hwe Huh.
10.13(1) Consulting Agreement between the Registrant and Mr. Chong-Moon Lee.
10.14(1) Mutual Release among the registrant, Messrs. Lee and Huh, and
certain other parties.
10.15(1) Facility Lease (2880 Junction Avenue, San Jose, CA).
10.16(1) Facility Lease (835 Sinclair Frontage Road Drive, Milpitas, CA).
10.17 Facility Lease (2895 Zanker Road, San Jose, CA).
10.18(2) Agreement and Plan of Reorganization among the Registrant,
Shakespeare Acquisition Corporation and Supra Corporation dated as
of August 7, 1995.
10.19(4) Stock Purchase Agreement by and among the Registrant, SPEA
Software AG and the Stockholders of SPEA Software AG dated as of
October 24, 1995.
10.20(8) Agreement and Plan of Merger by and among the Registrant, Boardwalk
Acquisition Corporation and Micronics Computers, Inc., dated as of
May 11, 1998.
10.21(3) 1993 Stock Incentive Plan.
10.22(4) Amendment No. 1 to Stock Purchase Agreement dated as of November 15,
1995 by and among the Registrant; Supra (Deutschland) GmbH; SPEA
Software AG; Spea-Beheer C.V.,TVM, Glenwood and Ulrich Seng for and
on behalf of the Selling Stockholders; and David Gill.
10.23*(7) Form of Change of Control Severance Agreement between the Registrant
and the executive officers listed below:
Franz Fichtner
C. Scott Holt
Hyung Hwe Huh
Wade Meyercord
Dennis D. Praske
James M. Walker
10.24(6) Employment Agreement between the Registrant and Mr. James M. Walker.
21.1(4) List of Significant Subsidiaries.
23.1 Consent of PricewaterhouseCoopers L.L.P., Independent Accountants.
24.1 Power of Attorney (included in this report under the caption
signatures).
27.1 Financial Data Schedule
- ----------------------------------------------------------------------------
* Management contract or compensation plan or arrangement required to be
filed as an exhibit to this report on Form 10-K pursuant to Item 14 (c)
of this report.
(1) Incorporated by reference to the Registration Statement on Form S-1
(File No. 33-89386), as amended, filed pursuant to the Securities Act
of 1933, as amended, relating to the initial public offering of Common
Stock.
(2) Incorporated by reference to the Registrant's current report on Form 8-K
(File No. 0-25580) filed pursuant to the Securities Exchange Act of
1934, as amended, on October 5, 1995.
(3) Incorporated by reference to the Registration Statement on Form S-8 (
File No. 33-98470) filed pursuant to the Securities Act of 1933, as
amended, on October 24, 1995.
(4) Incorporated by reference to Registration Statement on Form S-1 (File
No. 33-98618), as amended, filed pursuant to the Securities Act of 1933,
as amended.
(5) Incorporated by reference to the Registration Statement on Form S-8
(File No. 333-11147) filed pursuant to the Securities Act of 1933, as
amended, on August 11, 1998.
(6) Incorporated by reference to Form 10-K for the year 1996 (File No.
000-25580) filed pursuant to the Securities Exchange Act of 1934, as
amended, on March 28, 1997.
(7) Incorporated by reference to Form 10-K for the year 1997 (File No.
000-25580) filed pursuant to the Securities Exchange Act of 1934, as
amended, on March 24, 1998.
(8) Incorporated by reference to the Registrant's Tender Offer Statement
on Schedule 14D-1 filed with the Commission on May 15, 1998, as amended.
(b) Reports on Form 8-K
1. A report on Form 8-K (File No. 0-25580) was filed by the
Registrant pursuant to the Securities Exchange Act of 1934, as amended, on
November 16, 1998, relating to a press release issued November 12, 1998.
(c) Exhibits
See (a) above
(d) Financial Statement Schedules
See (a) above
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized on March 31, 1999.
DIAMOND MULTIMEDIA SYSTEMS, INC
/s/ William J. Schroeder
----------------------
By: William J. Schroeder
President and Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints William J. Schroeder and James M. Walker, jointly and
severally, his attorneys-in-fact, each with the power of substitution for him in
any and all capacities, to sign any amendments to this report, and to file the
same, with exhibits thereto and other documents in connection therewith, with
the Securities and Exchange Commission, hereby ratifying and confirming that
each of said attorneys-in-fact, or his substitute or substitutes, may do or
cause to be done by virtue hereof.
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
Signature Title Date
- --------------------------- ---------------------------------- --------------
/s/ William J. Schroeder Director, Chief Executive Officer March 31, 1999
- --------------------------- and President (Principal Executive
William J. Schroeder Officer)
/s/ James M. Walker Chief Financial Officer (Principal March 31, 1999
- --------------------------- Financial and Accounting Officer)
James M. Walker
/s/ Bruce C. Edwards Director March 31, 1999
- ---------------------------
Bruce C. Edwards
/s/ Carl W. Nuen Director March 31, 1999
- ---------------------------
Carl W. Nuen
/s/ Gregorio Reyes Director March 31, 1999
- ---------------------------
Gregorio Reyes
/s/ Jeffrey D. Saper Director March 31, 1999
- ---------------------------
Jeffrey D. Saper
/s/ James T. Schraith Director March 31, 1999
- ---------------------------
James T. Schraith
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders
Diamond Multimedia Systems, Inc.
In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, cash flows, and
stockholders' equity (deficit) present fairly, in all material respects,
the financial position of Diamond Multimedia Systems, Inc. and its
subsidiaries at December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the
period ended December 31, 1998, in conformity with generally accepted
accounting principles. These financial statements are the responsibility
of the company's management; our responsibility is to express an opinion
on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted
auditing standards, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant
estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable
basis for the opinion expressed above.
/S/ PricewaterhouseCoopers LLP
San Jose, California
January 29, 1999
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
December 31,
----------------------
1998 1997
---------- ----------
ASSETS
Current assets:
Cash and cash equivalents........................... $24,621 $85,929
Restricted cash..................................... 5,500 0
Short-term investments.............................. 5,951 4,136
Trade accounts receivable, net of allowance for
doubtful accounts of $2,096 and $2,440 in 1998
and 1997, respectively............................ 94,027 98,777
Inventories......................................... 48,892 78,647
Prepaid expenses and other current assets........... 13,041 6,350
Income taxes receivable............................. 9,735 24,929
Deferred income taxes............................... 50,071 14,679
---------- ----------
Total current assets.............................. 251,838 313,447
Property, plant and equipment, net.................. 27,288 15,216
Other assets........................................ 1,415 3,616
Goodwill, net....................................... 26,369 5,275
---------- ----------
Total assets................................. $306,910 $337,554
========== ==========
LIABILITIES
Current liabilities:
Current portion of long-term debt................... $45,516 $36,455
Trade accounts payable.............................. 75,727 98,764
Accrued liabilities................................. 21,979 17,667
Deferred income..................................... 7,200 0
Income taxes payable................................ 8,568 2,274
---------- ----------
Total current liabilities.................... 158,990 155,160
Long-term debt, net of current portion................ 1,550 1,873
---------- ----------
Total liabilities............................ 160,540 157,033
---------- ----------
Commitments and contingencies (Notes 4, 5 and 10)
Inventories, net
SHAREHOLDERS' EQUITY
Preferred stock, par value $.001; Authorized -
8,000 shares in 1998 and 1997, none issued
and outstanding.................................... -- --
Common stock, par value $.001; Authorized -
75,000 in 1998 and 1997; issued and
outstanding - 35,244 in 1998 and
34,491 in 1997..................................... 35 34
Additional paid-in capital............................ 313,214 307,877
Distributions in excess of net book value (Note 1).... (56,775) (56,775)
Accumulated deficit (110,104) (70,615)
---------- ----------
Total shareholders' equity............................ 146,370 180,521
---------- ----------
Total liabilities and shareholders' equity..... $306,910 $337,554
========== ==========
The accompanying notes are an integral part of these
consolidated financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
Net sales................................. $608,581 $443,281 $598,050
Cost of sales............................. 541,894 387,486 485,284
---------- ---------- ----------
Gross profit............................ 66,687 55,795 112,766
---------- ---------- ----------
Operating expenses:
Research and development................ 29,923 24,886 18,824
Selling, general and administrative..... 97,656 85,684 66,209
Amortization of intangibles............. 2,587 3,006 5,025
Write-off of intangibles................ -- 9,938 --
Restructuring expenses.................. 2,939 -- --
---------- ---------- ----------
Total operating expenses........ 133,105 123,514 90,058
---------- ---------- ----------
Income (loss) from operations............. (66,418) (67,719) 22,708
Interest income (expense), net............ 277 1,696 1,979
Other income, net......................... (2,716) 873 1,245
---------- ---------- ----------
Income (loss) before provision
(benefit) for income taxes......... (68,857) (65,150) 25,932
Provision (benefit) for income taxes...... (29,368) (19,545) 9,595
---------- ---------- ----------
Net income (loss)......................... ($39,489) ($45,605) $16,337
========== ========== ==========
Net income (loss) per share:
Basic.............................. ($1.13) ($1.33) $0.48
========== ========== ==========
Diluted............................ ($1.13) ($1.33) $0.46
========== ========== ==========
Accrued liabilities
Shares used in per share calculations:
Basic.............................. 34,863 34,322 34,351
Diluted............................ 34,863 34,322 35,194
The accompanying notes are an integral part of these
consolidated financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS)
Distributions
Common Stock Additional in Excess
------------------- Paid-In of Net Book Accumulated
Shares Amount Capital Value Deficit Total
--------- --------- ---------- ------------- ------------ ------------
BALANCES, JANUARY 1, 1996......... 34,673 $35 $306,697 ($56,775) ($41,347) $208,610
Stock options exercised......... 273 969 -- -- 969
Repurchase of common stock...... (702) (1) (34) -- -- (35)
Payment of note receivable
from Shareholder............... (109) -- (3,196) -- -- (3,196)
Sale of shares under
Employee Stock Purchase Plan... 28 -- 1,167 -- -- 1,167
Tax benefit of stock options.... 443 -- -- 443
Net income...................... -- -- -- -- 16,337 16,337
--------- --------- ---------- ------------- ------------ ------------
BALANCES, DECEMBER 31, 1996....... 34,163 34 306,046 (56,775) (25,010) 224,295
Stock options exercised......... 339 -- 1,232 -- -- 1,232
Repurchase of common stock...... (115) -- (7) -- -- (7)
Sale of shares under
Employee Stock Purchase Plan... 104 -- 606 -- -- 606
Net loss........................ -- -- -- -- (45,605) (45,605)
--------- --------- ---------- ------------- ------------ ------------
BALANCES, DECEMBER 31, 1997....... 34,491 34 307,877 (56,775) (70,615) 180,521
Stock options exercised......... 508 1 3,299 -- -- 3,300
Repurchase of common stock...... (55) -- (5) -- -- (5)
Sale of shares under
Employee Stock Purchase Plan... 300 -- 1,783 -- -- 1,783
Tax benefit of stock options.... -- -- 260 -- -- 260
Net loss........................ -- -- -- -- (39,489) (39,489)
--------- --------- ---------- ------------- ------------ ------------
BALANCES, DECEMBER 31, 1998....... 35,244 $35 $313,214 ($56,775) ($110,104) $146,370
========= ========= ========== ============= ============ ============
The accompanying notes are an integral part of these
consolidated financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
Years Ended December 31,
-----------------------------
1998 1997 1996
--------- --------- ---------
Cash flows from operating activities:
Net income (loss).............................. ($39,489) ($45,605) $16,337
Adjustments to reconcile net income (loss)
to net cash provided by (used in)
operating activities:
Write-off of in-process technology and
intangibles.................................. -- 9,938 --
Depreciation and amortization.................. 9,188 8,224 8,371
Provision for doubtful accounts................ 0 952 1,026
Provision for excess and obsolete
inventories.................................. 13,048 11,580 14,249
Deferred income taxes.......................... (35,392) 6,430 (5,415)
Loss on sale of equity interest................ 1,205 -- --
Loss on disposal of property and equipment..... 79 332 --
Changes in assets and liabilities:
Trade accounts <F1>............................ 4,991 (14,461) 17,475
Income taxes receivable........................ 15,454 (24,929) --
Inventories.................................... 20,966 (26,523) 2,981
Trade accounts payable and other liabilities... (24,197) 32,195 (24,524)
Deferred income................................ 7,200 -- --
Prepaid expenses and other assets.............. (5,415) (357) (3,596)
--------- --------- ---------
Net cash provided by (used in) operating
activities <F1>................................ (32,362) (42,224) 26,904
--------- --------- ---------
Cash flows from investing activities:
Sale of Micronics building..................... 6,310 -- --
Purchase of Micronics, net of cash acquired.... (21,626) -- --
Purchase of DigitalCast, net of cash acquired.. (2,234) -- --
Purchases of property and equipment............ (18,269) (7,219) (6,077)
Other equity investments....................... (1,150) -- --
Proceeds from sale of equity interest.......... 1,642 -- --
Purchases and proceeds from maturities of
short-term investments....................... (1,815) (4,136) 12,232
--------- --------- ---------
Net cash provided by (used in) investing
activities..................................... (37,142) (11,355) 6,155
--------- --------- ---------
Cash flows from financing activities:
Proceeds from issuance of common stock......... 5,344 1,838 2,136
Proceeds from term loans and revolving
credit facilities............................ 89,028 153,415 46,778
Payments and maturities of term loans and
revolving credit facilities.................. (79,911) (135,059) (55,177)
Maturities of term loans and revolving
Investment in restricted certificates of deposit (5,500) -- --
Proceeds from capital lease financing.......... -- -- 197
Repayments of capital lease financing.......... (760) (826) (782)
Repurchases of common stock.................... (5) (7) (35)
--------- --------- ---------
Net cash provided by (used in) financing
activities..................................... 8,196 19,361 (6,883)
--------- --------- ---------
Net increase (decrease) in cash and cash
equivalents <F1>............................... (61,308) (34,218) 26,176
Cash and cash equivalents at beginning of period.. 85,929 120,147 93,971
--------- --------- ---------
Cash and cash equivalents at end of period <F1>... $24,621 $85,929 $120,147
========= ========= =========
Supplemental disclosure of cash flow information:
Income taxes paid (refunded) during the
period, net ($21,072) $1,825 $11,583
========= ========= =========
Interest paid during the period $2,571 $1,472 $1,675
========= ========= =========
<FN>
<F1>
The 1998 values have been changed to correct a clerical error in the original
filing.
</FN>
The accompanying notes are an integral part of these
consolidated financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation; Reorganization; Public Offerings;
Acquisition of Supra, Spea, Micronics, and DigitalCast
Diamond Multimedia Systems, Inc. a Delaware Corporation, (the
"Company") designs, develops, manufacturers and markets multimedia add-
in subsystems for IBM-compatible personal computers and fax/modem
products for the PC and Macintosh markets.
The Company was formed in December 1994 and acquired substantially
all of the outstanding common stock of Diamond Multimedia Systems, Inc.,
a California Corporation ("Diamond CA"), on January 1, 1995, the last
day of the 1994 fiscal year (the "Reorganization"). The total
acquisition price was approximately $99,192,000 which consisted of
$82,664,000 of cash paid after the end of fiscal 1994 on January 3,
1995, $8,800,000 of subordinated promissory notes, $7,517,000 of
mandatorily-redeemable preferred stock and $211,000 of common stock. In
connection with this transaction, the Company issued $34,167,000 of
subordinated promissory notes (including the $8,800,000 issued to the
Diamond CA shareholders); $29,174,000 of mandatorily redeemable
preferred stock (including, $7,517,000 issued to the Diamond CA
shareholders) and $826,000 of common stock (including $211,000 issued to
the Diamond CA shareholders). On January 3, 1995, Diamond CA was merged
into the Company.
The transaction has been accounted for as a recapitalization, and
accordingly, no change in the accounting basis of Diamond CA's assets
has been made in the accompanying consolidated financial statements. The
amount of cash paid and securities issued to the shareholders of Diamond
CA of $99,192,000 exceeded Diamond CA's net assets of approximately
$42,417,000 on the date of the transaction by $56,775,000. This amount
has been recorded in the equity section as distributions in excess of
net book value.
On April 19, 1995, the Company completed an initial public offering
of 7,475,000 shares of common stock at a price of $17.00 per share, all
of which shares were sold by the Company. The net proceeds realized by
the Company from this offering were approximately $117,188,000 which
were used by the Company to repay all of the Company's senior debt and
subordinated promissory notes payable and to redeem the Company's
mandatorily redeemable preferred stock.
The Company acquired all of the outstanding common stock of Supra
Corporation ("Supra") and SPEA Software AG ("Spea") on September 20,
1995 and November 15, 1995, respectively, in two purchase business
combination transactions.
In November, 1995, the Company sold 3,150,000 shares of common stock
in a Public Offering at a price of $31.25 per share raising net proceeds
of approximately $93,494,000.
The Company acquired all of the outstanding common stock of Micronics
Computers, Inc. ("Micronics") and DigitalCast, Inc. ("DigitalCast") on
June 26, 1998 and September 4, 1998, respectively, in two purchase
business combination transactions.
2. Summary of Significant Accounting Policies
Basis of Consolidation
The accompanying consolidated financial statements include the
accounts of the Company and its wholly owned subsidiaries. The accounts
of the Company's wholly owned subsidiaries, Supra, SPEA, Micronics and
DigitalCast, have been included in the accompanying consolidated
financial statements as of the date of acquisition, September 20, 1995,
November 15, 1995, June 26, 1998, and September 4, 1998, respectively.
All intercompany transactions and balances have been eliminated in
consolidation.
Fiscal Year-End
During 1996 and prior years, the Company operated under a 52-53 week
fiscal year which ended on the Sunday closest to December 31. As a
result, the fiscal year may not have ended as of the same day as the
calendar year. Fiscal 1996 was a 52 week year. For convenience of
presentation, the accompanying consolidated financial statements of the
Company for 1996 and 1995 have been shown as ending on December 31 of
each year. During 1997, the Company changed its fiscal year end to a
calendar year. Net sales for 1997 include approximately $29,000,000 due
to the change in year-end.
Cash and Cash Equivalents
All highly liquid investments with an original maturity of three
months or less from the date of purchase and money market funds are
considered cash equivalents. Cash and cash equivalents consist primarily
of commercial paper held by investment banks in the U.S. along with a
lesser amount of cash deposits in banks in the U.S., Japan, Germany and
the United Kingdom.
Restricted Cash
At December 31, 1998, restricted cash consisted of $5.5 million in
certificates of deposit principally used as collateral for standby
letters of credit.
Short-Term Investments
At December 31, 1998, short-term investments consisted of debt
securities with a remaining maturity of more than three months and less
than one year from the date of purchase. The Company had determined that
all of its debt securities should be classified as available-for-sale.
The difference between the cost basis and the market value of the
Company's investments was not material at December 31, 1998 and 1997.
The Company's short-term investments consisted of corporate bonds at
December 31, 1998 and municipal bonds at December 31, 1997.
Accounts Receivable
The Company participates in cooperative advertising and similar
programs with certain distributors and retailers. These programs are
utilized on a pre-approved basis and result in credits against the
customers' trade accounts. The Company offers limited price protection
to its customers. Accruals based on estimated costs of future claims are
reflected in the accompanying consolidated financial statements.
Inventories
Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market. Inventories are summarized as follows (in
thousands):
December 31,
---------------------
1998 1997
---------- ----------
Raw material........................... $17,388 $29,876
Work in process........................ 20,739 40,286
Finished goods......................... 10,765 8,485
---------- ----------
$48,892 $78,647
========== ==========
The Company is currently dependent on sole or limited suppliers for
certain key components used in its products, particularly VRAM and DRAM
memory and other chipsets, which may cause shortages that limit
production capacity. There can be no assurance that such shortages will
not adversely affect future operating results. The Company may purchase
certain components, resulting in excess inventory and reducing the
Company's liquidity or, in the event of inventory obsolescence or a
decline in the market value of such inventory, causing inventory write-
offs against the Company's operating results.
The Company has approximately $5 million of inventory in excess of
its normal short-term needs for certain product lines at December 31,
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 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.
Property, Plant and Equipment
Property, plant and equipment are stated at cost and are depreciated
using the straight-line and double declining balance methods over their
estimated useful lives ranging from three to thirty and one-half years.
Upon disposal, the assets and related accumulated depreciation are
removed from the Company's accounts, and the resulting gains or losses
are reflected in operations. Property, plant and equipment consisted of
the following (in thousands):
December 31,
---------------------
1998 1997
---------- ----------
Furniture and equipment................ $35,023 $20,732
Building, land and leasehold
improvements......................... 6,969 3,912
---------- ----------
41,992 24,644
Less accumulated depreciation.......... 14,704 9,428
---------- ----------
$27,288 $15,216
========== ==========
The Company incurred non-cash depreciation expense of $6.6 million, $5.2
million and $3.3 million in 1998, 1997 and 1996, respectively, the
majority of which was related to computer equipment and software.
Disposals were immaterial.
Goodwill and Other Intangible Assets
Goodwill and other intangible assets arose primarily from a series of
equity acquisitions. These include Supra on September 20, 1995, Spea on
November 15, 1995, Binar Graphics, Inc. on November 15, 1997, Micronics
on June 26, 1998, and DigitalCast on September 4, 1998. Goodwill is
being amortized on a straight-line basis over seven years. The Company
assesses the recoverability of intangible assets by determining whether
the amortization of the asset's net book value over its remaining life
can be recovered through projected undiscounted future cash flows.
Accordingly, the Company wrote-off $9.9 million of intangible assets in
the second quarter of 1997 to reflect an impairment in the value
of goodwill and existing technology associated with the acquisitions of
Supra and Spea. The anticipated cash flows related to those products
indicated that the recoverability of those assets was not reasonably
assured.
Intangible assets consist of the following at December 31, 1998 and 1997,
respectively (in thousands):
December 31,
---------------------
1998 1997
---------- ----------
Goodwill............................... 42,198 18,328
Less accumulated amortization 15,829 13,053
---------- ----------
$26,369 $5,275
========== ==========
Warranties
The Company's products are generally warranted for one to five years.
Estimated future costs of repair, replacement, or customer
accommodations are reflected in the accompanying consolidated financial
statements.
Revenue Recognition
Revenue is recognized upon shipment of the product to the customer.
Certain of the Company's sales are subject to a limited right of return.
The Company estimates product returns and reduces sales to reflect
anticipated product returns.
Research and Development
Research and development expenditures are charged to operations as
incurred.
Advertising Costs
Advertising costs are charged to operations as incurred. Advertising
costs were $14,935,000 $11,233,000, and $11,555,000 in 1998, 1997, and
1996 respectively.
Income Taxes
The Company uses the liability method to calculate deferred income
taxes. The realization of deferred tax assets is based on historical tax
positions and expectations about future taxable income.
Fair Value of Financial Instruments
Carrying amounts of certain of the Company's financial instruments
including cash and cash equivalents, accounts receivable, accounts
payable and other accrued liabilities approximate fair value due to
their short maturities. Based on borrowing rates currently available to
the Company for loans with similar terms, the carrying value of its debt
obligations approximates fair value. Estimated fair values for
marketable securities which are separately disclosed elsewhere, are
based on quoted market prices for the same or similar instruments (see
Short-Term Investments above). The estimated fair value of the Company's
equity investments could not be made without incurring excessive cost.
Concentrations of Credit Risk
Financial instruments which potentially subject the Company to
concentration of credit risk are primarily accounts receivable and cash
equivalents.
The Company sells its products through distributors, OEMs and
retail/mass merchant outlets primarily in the regions of North America,
Europe and Asia. The Company performs ongoing credit evaluations of its
customers and, generally, does not require collateral for its
receivables and maintains an allowance for potential credit losses. The
allowance for non-collection of accounts receivable is maintained for
potential credit losses and is based upon the expected collectibility of
accounts receivable.
Cash and cash equivalents are invested primarily in deposits with
several banks in the United States, United Kingdom, Germany and Japan.
Deposits in these banks may exceed the amount of insurance, if any,
provided on such deposits. The Company places its cash equivalents in
investment grade, short-term debt instruments and limits its amount of
credit exposure to any one issuer. The Company has not experienced any
losses on its cash and cash equivalents.
Foreign Currency Accounting
Substantially all of the Company's sales are denominated in U.S.
dollars and the U.S. dollar is the functional currency for all foreign
operations. Foreign exchange gains and losses, which result from the
process of remeasuring foreign currency financial statements into U.S.
dollars are included in the statement of operations. The Company
recorded a net foreign currency translation loss in other expense of
$668,000 in 1998 and net foreign currency translation gains in other
income of $93,000 and $609,000 during 1997 and 1996, respectively.
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 as their effect is anti-dilutive.
The following is a reconciliation of the numerator (net income) and
denominator (number of shares) used in the basic and diluted EPS calculation:
(Dollar amounts, in thousands)
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
Basic EPS:
Net income (loss)......................... ($39,489) ($45,605) $16,337
Average Common Shares Outstanding......... 34,955 34,322 34,351
---------- ---------- ----------
Basic EPS ($1.13) ($1.33) $0.48
========== ========== ==========
Diluted EPS:
Net income (loss)......................... ($39,489) ($45,605) 16,337
Average Common Shares Outstanding......... 34,955 34,322 34,351
Stock options............................. -- -- 843
Total Shares.............................. 34,955 34,322 35,194
---------- ---------- ----------
Diluted EPS ($1.13) ($1.33) $0.46
========== ========== ==========
For 1998 and 1997, approximately 897,000 stock options and
1,158,000 stock options, respectively, were not included in the
calculation of diluted EPS as their effect would be anti-dilutive.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities
and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
Comprehensive Income
The Company has adopted the Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" (SFAS 130) effective
December 31, 1998. SFAS 130 establishes standards for reporting and
display of comprehensive income and its components for general-purpose
financial statements. Comprehensive income is defined as net income plus
all revenues, expenses, gains and losses that are excluded from net
income in accordance with generally accepted accounting principles. For
the years ended December 31, 1996, 1997 and 1998, there are no material
differences between comprehensive income and net income.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Investments and Hedging Activities" (SFAS 133) which
establishes accounting and reporting standards requiring that every
derivative instrument be recorded in the balance sheet as either an
asset or liability measured at its fair value. The statement also
requires that changes in the derivative's fair value be recognized
currently in earnings unless specific hedge accounting criteria are met.
SFAS 133 is effective for fiscal years beginning after June 15, 1999.
The Company does not expect the adoption of SFAS 133 to have a material
effect on the Company's consolidated financial statements.
3. Accrued Liabilities
Accrued liabilities consisted of the following (in thousands):
December 31,
---------------------
1998 1997
---------- ----------
Warranty............................... $2,700 $4,110
Accrued payroll and employee
related costs........................ 5,422 7,405
Accrued royalties...................... 2,526 3,542
Tax refund reserve..................... 5,738 --
Other.................................. 5,593 2,610
---------- ----------
$21,979 $17,667
========== ==========
4. Debt Agreements
The following represents the Company's debt at December 31 (in thousands):
December 31,
---------------------
1998 1997
---------- ----------
Domestic Lines of Credit............... $35,000 $22,000
Japanese Bank Line of Credit........... 2,743 4,536
European Lines of Credit............... 7,068 8,338
Capital Lease Obligations.............. 310 1,070
Other.................................. 1,944 2,384
---------- ----------
47,065 38,328
Less current portion................... 45,516 36,455
---------- ----------
$1,549 $1,873
========== ==========
At December 31, 1998, the Company had two domestic bank credit
facilities: a $30 million line of credit permitting borrowings at the
bank's reference rate or a formula Libor based rate and a $15 million
line of credit permitting borrowings at the bank reference rate or a
formula Libor based rate. Borrowings under these lines at December 31,
1998 were $25 million and $10 million, respectively. Further, the
agreements for these lines of credit expire in May 1999 and January
1999, respectively. In January 1999 the Company closed a new $50 million
domestic bank credit facility and the previous facilities were paid off
and closed. The covenants covering this new debt agreement pertain to
minimum levels of collateral coverage and tangible net worth, quarterly
profitability beginning with the quarter ending March 31, 1999, and
minimum levels of liquidity.
Additionally, the Company has credit facilities under foreign lines
of credit. At December 31, 1998, the Company's Japanese subsidiary had a
Yen line of credit entitling it to borrow up to approximately $3.0
million. The line of credit is collateralized by a stand-by letter of
credit from the Company and accrues interest at the bank's variable
rate. Borrowings were $2.7 million under this facility at December 31,
1998. At December 31, 1998, the Company's Spea subsidiary had a 5
million DeustcheMark line of credit (approximately $3.0 million at
December 31, 1998) with a German bank. Additionally, the Company had a
foreign line of credit of 10 million DeustcheMarks (approximately $6.0
million at December 31, 1998). Of the $9 million available under these
lines, $5.7 million was being used as of December 31, 1998. These
agreements expired January 31, 1999. The bank has extended an open line
of credit for a total of 10 million DeustcheMarks (approximately $6.0
million at December 31, 1998).
At December 31, 1998, the Company's weighted average interest rate on
short-term borrowings was 7.03%, versus 7.80% at December 31, 1997.
The Company has various capital lease obligations payable through
2000.
As of December 31, 1998, the Company's future payments on debt
related to notes payable, lines of credit and capital lease obligations
are $45,522,000, $199,000, $581,000, $61,000, $66,000 and $636,000 in
fiscal years 1999, 2000, 2001, 2002, 2003 and thereafter, respectively.
5. Commitments
The Company occupies facilities in several countries including the
U.S., England, France, Germany, Japan, and Singapore and is obligated
under several leases expiring through 2001. Under the leases, the
Company is responsible for insurance, maintenance and property taxes.
The Company's headquarters facility lease agreement includes an option
to extend the lease for one five year period. During the extension
period, all terms and conditions under the agreement would remain the
same, except that the monthly rental payments for the option period
shall be the fair market value of the facility.
Future annual minimum payments under the Company's operating leases are as
follows at December 31, 1998 (in thousands):
1999................................... $3,418
2000................................... 3,163
2001................................... 2,173
2002................................... 668
2003................................... 57
Thereafter............................. --
----------
Total $9,479
==========
6. Shareholders' Equity
Preferred Stock
Under the Company's Articles of Incorporation, the Board of Directors
may determine the rights, preferences and terms of the Company's
undesignated preferred stock.
Stock Option Plans
The Company has four fixed stock option plans. Under the Company's
stock option plans, options generally vest over a four year period and
they expire five to ten years from the date of grant. Options may be
granted to directors, officers, consultants and employees at prices not
less than the fair market value at the date of grant. At December 31,
1998, approximately 1,222,000 shares were available for future grants.
On April 16, 1997, the Board of Directors approved the repricing of
all employee stock options granted with exercise prices higher than
$7.625 per share. Approximately 568,000 shares were repriced to $7.625
per share. The Board of Directors approved the repricing with the
general condition that these options cannot be exercised at the new
price of $7.625 until April 1, 1998.
On October 14, 1998, the Board of Directors approved the further
repricing of all employee stock options granted with exercise prices
higher than $3.0625 per share. Approximately 4,387,000 shares were
repriced to $3.0625 per share. The Board of Directors approved the
repricing with the general condition that these options cannot be
exercised until April 19, 1999.
In January 1995, the 1995 Director Option Plan (the "Director Plan")
was adopted by the Board of Directors. The Director Plan provides for
the grant of options to purchase the Company's common stock to directors
who are not employees of the Company. A total of 175,000 shares of
common stock have been authorized for issuance under the Director Plan.
In May 1998, the shareholders approved changes to the plan increasing
the number of shares reserved (i) for initial grants to non-employee
directors from 30,000 shares to 40,000 shares and (ii) the subsequent
annual grants to non-employee directors from 7,500 shares to 10,000
shares. Further, the stockholders approved one special grant of 7,500
shares to each of three non-employee directors then existing. Each
nonemployee director who joins the board will automatically be granted
an option to purchase 40,000 shares of common stock at a price equal to
the fair market value on the date of grant and upon each reelection to
the Board will be granted an additional option to purchase 10,000 shares
of common stock at a price equal to the fair market value on the date of
grant. The 40,000 share grants vest at the rate of 25% of the option
shares upon the first anniversary of the date of grant and 1/48th of the
option shares per month thereafter, and the 10,000 share grants vest
four years after grant, in each case unless terminated sooner upon the
termination of the optionee's status as a director or otherwise pursuant
to the Director Plan. In the event of a merger of the Company with or
into another corporation or a consolidation, acquisition of assets or
other change in control transaction involving the Company, each option
becomes exercisable in full or will be assumed for an equivalent option
substituted by the successor corporation. The Director Plan expires in
2005, unless terminated earlier by the Board of Directors. As of
December 31, 1998, approximately 157,500 shares have been issued under
the Director Plan.
In connection with the acquisition of Supra, the Company assumed the
Supra 1993 Stock Incentive Plan. Under the Plan the equivalent of
381,000 shares of the Company's common stock were granted to employees
of Supra upon the acquisition of Supra by the Company at an exercise
price determined pursuant to a calculation described in the Plan
document. These stock options generally vest over three years from the
date of grant. Such options are included in the activity for the
Company's stock options described above.
The Company has also issued options outside of the four fixed plans
amounting to 241,497, 430,000, and 225,000 shares in 1998, 1997, and
1996, respectively. These options vest under various periods up to a
maximum vesting period of 4 years.
The fair value of each option grant is estimated at the date of grant using
the Black-Scholes pricing model with the following weighted average assumptions
for grants in 1998, 1997 and 1996:
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
Risk-free Interest Rate................ 4.55% 6.36% 5.57%
Expected life.......................... 4 years 4 years 2 years
Volatility............................. 81.6% 61.0% 50.8%
Dividend Yield......................... -- -- --
A summary of the Company's option activity as of December 31, 1998, 1997, and
1996 and changes during the year ending on those dates are as follows (amounts
in thousands, except share data):
Outstanding Options
---------------------
Weighted
Average
Number of Exercise
Shares Price
---------- ----------
Balance, December 31, 1995............... 2,376 $19.03
Options granted........................ 1,695 11.84
Options exercised...................... (117) 3.21
Options canceled....................... (511) 20.41
----------
Balance, December 31, 1996............... 3,443 7.90
Options granted........................ 3,386 8.83
Options exercised...................... (293) (4.37)
Options canceled....................... (1,539) 10.92
----------
Balance, December 31, 1997............... 4,997 7.89
Options granted........................ 6,393 4.29
Options exercised...................... (504) 6.47
Options canceled....................... (5,226) 8.59
----------
Balance, December 31, 1998............... 5,660 $3.45
========== ==========
At December 31, 1998, 1997 and 1996 vested options to purchase
2,124,000 shares, 1,232,000 shares, and 590,000 shares, respectively,
were unexercised. The weighted average fair value of those options
granted in 1998, 1997 and 1996 was $2.67 per share, $4.76 per share, and
$3.78 per share, respectively.
The following table summarizes information about fixed stock options outstanding
at December 31, 1998:
Options Outstanding Options Exercisable
---------------------------------- ----------------------
Weighted-
Average Weighted- Weighted-
Number Remaining Average Number Average
Range of Outstanding Contractual Exercise Exercisable Exercise
Exercise Prices at 12/31/98 Life(Years) Price at 12/31/98 Price
- ---------------- ------------ ----------- --------- ------------ ---------
$0.07 - $3.01 74,055 4.62 $1.96 73,604 $1.97
$3.06 - $3.06 5,186,495 8.39 $3.06 1,959,525 $3.06
$6.01 - $19.06 399,762 8.96 $8.72 90,474 $9.99
------------ ------------
Total 5,660,312 2,123,603
============ ============
At December 31, 1998, the Shareholders have reserved 9,212,500 under
the 1998, 1994 and 1992 Stock Option Plans and 175,000 shares under the
Director Plan.
Employee Stock Purchase Plan
During 1995, the 1995 Employee Stock Purchase Plan (the "Purchase
Plan") was adopted by the Board of Directors. As of December 31, 1998,
a total of 650,000 shares of common stock have been authorized for
issuance under the Purchase Plan. The Purchase Plan provides for
eligible employees to purchase common stock at a price equal to 85% of
the fair market value at certain specified dates. During 1998 and 1997,
the Company issued 300,000 and 104,000 shares of common stock,
respectively, under this plan.
Fair value for the purchase rights issued under the Company's Employee Stock
Purchase Plan, described above, is determined under the Black-Scholes valuation
model using the following assumptions for 1998, 1997 and 1996:
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
Risk-free Interest Rate................ 5.05% 5.12% 5.44%
Expected life.......................... 6 months 6 months 6 months
Volatility............................. 81.6% 61.0% 50.8%
Dividend Yield......................... -- -- --
The weighted average fair market value of those purchase rights
granted in 1998, 1997 and 1996 was $3.23 per share, $3.89 per share and
$13.17 per share respectively.
The Company has adopted the disclosure-only provisions of the
Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-based Compensation." Accordingly, no compensation
cost has been recognized for the Company's Stock Plans. Had compensation
cost for the Stock Plans been determined based on the fair market value
at the grant date for awards in 1998 and 1997, consistent with the
provisions of SFAS No. 123, the Company's net income and net income per
share for the years ended December 31, 1998, 1997 and 1996 would have been
reduced as follows:
(amounts in thousands except per share data)
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
Net income (loss) - as reported.......... ($39,489) ($45,605) $16,337
Net income (loss) - proforma............. ($40,980) ($54,420) $11,307
Net income (loss) per share - as reported ($1.13) ($1.33) $0.46
Net income (loss) per share - proforma... ($1.17) ($1.59) $0.33
Reorganization and Stock Repurchase Agreement
Effective with the Reorganization described in Note 1, all of the
outstanding unexercised options of Diamond CA were canceled and new
options were issued at $.07 per share, the fair market value of the
Company's common stock immediately after the Reorganization. During the
year ended December 31, 1995, certain option holders exercised their
option to purchase 5,430,000 shares of the Company's common stock
pursuant to restricted stock purchase agreements. Under the terms of the
restricted stock purchase agreements, the Company's right to repurchase
the stock expires monthly over four years from the date of grant of the
original stock options. In addition to the exercise of stock options
described above, on January 3, 1995, the Company issued 2,615,000 shares
of common stock to certain employees, officers, board members, and
consultants under restricted stock purchase agreements. Under the terms
of the restricted stock repurchase agreements, the right to repurchase
this stock expires monthly over four years from the original date of
grant as determined by the Board of Directors. Shares subject to
repurchase may be repurchased by the Company at the end of each
individual's association with the Company. As of December 31, 1998,
29,000 shares of common stock were subject to repurchase by the Company.
Common Stock Dividends
The Company has never declared or paid cash dividends on its common
stock. The Company's bank loan agreement prohibits the payment of cash
dividends on the common stock without prior approval.
7. Geographic Region and Major Customer Information
In 1998, 1997, and 1996, no single customer accounted for greater
than 10% of net sales. In addition, outside the United States, no one
country accounted for more than 10% of net sales. Revenues to geographic
regions reported below are based upon the customers' locations.
Essentially all the Company's current shipments and invoices are
denominated in U.S. dollars. The Company's foreign operations consist
principally of its foreign subsidiaries in Germany, the United Kingdom
and Japan. Long-lived assets, primarily fixed assets and unamortized
goodwill, are reported below based upon the location of the asset.
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
Net sales to geographic regions:
United States.......................... $326,915 $271,311 $369,367
Europe................................. 217,347 116,844 132,971
Far East and other..................... 64,319 55,126 95,712
---------- ---------- ----------
Net Sales.............................. $608,581 $443,281 $598,050
========== ========== ==========
Long-lived assets:
United States.......................... $48,296 $17,390 $19,028
Europe................................. 2,673 3,056 10,036
Far East and other..................... 2,688 44 46
---------- ---------- ----------
Total Assets........................... $53,657 $20,490 $29,110
========== ========== ==========
8. Income Taxes:
The provision (benefit) for income taxes consists of the following (in
thousands):
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
Current:
Federal................................ $0 ($18,873) $12,779
State.................................. 0 73 2,231
Foreign................................ 1,550 0 0
---------- ---------- ----------
1,550 (18,800) 15,010
---------- ---------- ----------
Deferred:
Federal................................ (20,647) 138 (14,568)
State.................................. (1,184) (883) (458)
Foreign................................ (9,087) -- 9,611
---------- ---------- ----------
(30,918) (745) (5,415)
---------- ---------- ----------
($29,368) ($19,545) $9,595
========== ========== ==========
The Company's effective tax rate differs from the statutory federal income
tax rate as shown in the following schedule:
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
Tax provision at federal statutory rate.. -35.0% -35.0% 35.0%
State taxes, net of federal tax benefit.. -1.7% -1.6% 3.4%
Tax provision at local country rates..... -5.8% -- --
Research and development tax credit...... -0.4% -0.3% -0.7%
Amortization of intangibles.............. 1.2% 6.0% 1.7%
Other.................................... -1.0% 0.9% -2.4%
---------- ---------- ----------
-42.7% -30.0% 37.0%
========== ========== ==========
The components of the deferred tax asset are as follows (in thousands):
December 31,
--------------------------------
1998 1997 1996
---------- ---------------------
Deferred tax assets:
Net operating loss carryforwards......... $40,607 $756 --
Sales returns and receivables allowances. -- -- 4145
Inventory valuation allowances........... 3,268 7,060 6307
Deferred revenue......................... 1,803 -- --
Warranty accruals........................ 534 1,465 1718
Compensation............................. 588 455 644
State taxes.............................. 1 -- 1019
Software amortization.................... 2,246 4,695 7350
All other................................ 1,024 248 761
---------- ---------- ----------
Total deferred tax assets........ $50,071 $14,679 $21,944
========== ========== ==========
The Company was not profitable in 1998 and has shown a cumulative
loss over the past three years. However, significant new business
contracts have been awarded to the company over the past several
months. These sales contracts are with established industry leaders and
cover a broad spectrum of the Company's products including
core graphics accelerators, Window NT workstation graphics accelerators,
modems and home networking. Based upon this incremental business and
related margins, management has determined that no valuation allowance is
necessary since it is more likely than not the deferred tax asset will
be realized.
The temporary non-deductible differences noted in the above table
(excluding net operating losses) are generally applicable to the
following years taxable income. They will also be replaced by new
temporary differences of a similar nature.
Net operating loss carryforwards will expire as follows (in thousands);
---------------------------------------------
Federal State Foreign Total
---------------------------------------------
2002 -- $5,405 -- $5,405
2003 -- $10,544 -- $10,544
2007 -- -- $2,863 $2,863
2018 $86,161 -- -- $85,161
No expiration -- -- $24,899 $24,899
---------- ---------- ---------- ------------
Total $86,161 $15,949 $27,762 $129,872
========== ========== ========== ============
9. Employee Benefit Plan
During 1993, the Company established a 401(k) tax-deferred savings
plan under which all employees meeting certain age and service
requirements may contribute up to 15% of their eligible compensation (up
to a maximum allowed under IRS rules). Contributions may be made by the
Company at the discretion of the Board of Directors. Contributions by
the Company amounted to $825,000, $671,000, and $616,000 in 1998, 1997,
and 1996, respectively.
10. 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. No trial date has been
set for any of these actions. 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. As the ultimate outcome of
these proceedings cannot be determined, 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.
11. Acquisitions
In June 1998, the Company acquired all the outstanding stock of
Micronics Computers, Inc. The acquisition was treated as a purchase and
accounted for using the purchase method. Micronics results are included
in the Company's financial statement from the date of acquisition. The
purchase price for Micronics was $32,596,000 or $20,192,000 net of
Micronics cash balances acquired. The following unaudited proforma
consolidated statement of operations assumes Micronics had been
purchased at the beginning of 1997.
Years Ended
December 31,
---------------------
Dollars in thousands 1998 1997
---------- ----------
Net sales................................ $626,803 $525,828
Net income (loss)........................ ($63,690) ($60,215)
========== ==========
Net income (loss) per share:
Basic............................ ($1.82) ($1.75)
========== ==========
Diluted.......................... ($1.82) ($1.75)
========== ==========
Shares used in per share calculations:
Basic............................ 34,955 34,322
Diluted.......................... 34,955 34,322
DIAMOND MULTIMEDIA SYSTEMS, INC.
SCHEDULE II-Valuation and Qualifying Accounts
DIAMOND MULTIMEDIA SYSTEMS, INC.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS (in thousands)
- -----------------------------------------------------------------------------
Balance Additions Balance
at Charged Deductions at
Beginning to Costs from End of
of Period & Expenses Reserves Adjustments(1) Period
----------- ----------- ---------- ------------- ----------
Year Ended December 31, 1998:
Accounts Receivable Allowances... $2,440 -- $2,189 $1,845 $251
Inventory Allowances............. $2,752 $13,048 $22,134 $12,201 ($6,334)
Year Ended December 31, 1997:
Accounts Receivable Allowances... $1,943 $952 $455 -- $2,440
Inventory Allowances............. $0 $11,580 $8,828 -- $2,752
Year Ended December 29, 1996:
Accounts Receivable Allowances... $1,959 $1,026 $1,042 -- $1,943
Inventory Allowances............. $5,063 $14,249 $5,557 -- $13,755
(1) Adjustments consist of opening balance allowances related to the
acquisitions of Micronics and DigitalCast.
DIAMOND MULTIMEDIA SYSTEMS, INC.
LIST OF EXHIBITS
Exhibit No. Description
10.17 Facilities Lease (2895 Zanker Road, San Jose, CA).
23.1 Consent of Pricewaterhouse Coopers L.L.P.
Independent Accountants
24.1 Power of Attorney (Included in this report under the caption
signatures).
27.1 Financial Data Schedule