UNITED STATES
SECURITIES & EXCHANGE COMMISSION
Washington, D.C. 20549
--------------------------
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1999
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
for the transition period from _______ to _______
Commission File Number 0-25580
DIAMOND MULTIMEDIA SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0390654
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2880 JUNCTION AVENUE, SAN JOSE, CALIFORNIA 95134
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (408) 325-7000
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
The number of shares outstanding of the registrant's common stock at
June 30, 1999 was 35,645,949.
DIAMOND MULTIMEDIA SYSTEMS, INC.
INDEX TO FORM 10-Q
PART I - FINANCIAL INFORMATION:
ITEM 1 - Financial Statements
Consolidated Balance Sheets as of June 30, 1999 and December 31, 1998
Consolidated Statements of Operations for the three months and six
months ended June 30, 1999 and June 30, 1998
Consolidated Statements of Cash Flows for the six months ended June 30,
1999 and June 30, 1998
Notes to Consolidated Financial Statements
ITEM 2 - Management's Discussion and Analysis of Financial Condition and
Results of Operations
ITEM 3 - Qualitative and Quantitative Disclosures of Market Risk
PART II - OTHER INFORMATION
ITEM 1 - Legal proceedings
ITEM 2 - Changes in securities
ITEM 3 - Defaults Upon Senior Securities
ITEM 4 - Submission of Matters to a Vote of Security Holders
ITEM 5 - Other Information
ITEM 6 - Exhibits and Reports on Form 8-K
SIGNATURES
PART I - FINANCIAL INFORMATION
ITEM 1 - Financial Statements
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
June 30, December 31,
1999 1998
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents........................ $15,653 $24,621
Restricted cash.................................. $4,750 $5,500
Short-term investments........................... 1,001 5,951
Trade accounts receivable, net of allowance
for doubtful accounts of $1,199 and $2,096
as of June 30, 1999 and December 31, 1998. 119,607 94,027
Inventories...................................... 46,504 48,892
Prepaid expenses and other current assets........ 8,698 13,041
Income taxes receivable.......................... 6,691 9,735
Deferred income taxes............................ 54,075 50,071
------------ ------------
Total current assets........................ 256,979 251,838
Property, plant and equipment, net............... 29,017 27,288
Other assets..................................... 1,350 1,415
Goodwill and other intangibles, net.............. 24,157 26,369
------------ ------------
Total assets................................ $311,503 $306,910
============ ============
LIABILITIES
Current liabilities:
Current portion of long-term debt................ $61,563 $45,516
Trade accounts payable........................... 80,225 75,727
Accrued liabilities.............................. 19,437 21,979
Deferred income.................................. 2,125 7,200
Income taxes payable............................. 8,203 8,568
------------ ------------
Total current liabilities................... 171,553 158,990
Long-term debt, net of current portion............. 1,413 1,550
------------ ------------
Total liabilities........................... 172,966 160,540
------------ ------------
STOCKHOLDERS' EQUITY
Preferred stock, par value $.001; Authorized -
8,000 shares at September 30, 1998 and
December 31, 1997; none issued and outstanding.. -- --
Common stock, par value $.001;
Authorized - 75,000 at June 30, 1999 and
December 31, 1998; Issued and outstanding -
35,646 at June 30, 1999 and 35,244 at
December 31, 1998................................ 36 35
Additional paid-in capital......................... 314,803 313,214
Distributions in excess of net book value.......... (56,775) (56,775)
Accumulated deficit................................ (119,527) (110,104)
------------ ------------
Total stockholders' equity...................... 138,537 146,370
------------ ------------
Total liabilities and stockholders' equity.... $311,503 $306,910
============ ============
The accompanying notes are an integral part of these consolidated condensed
financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- ---------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
Net sales........................ $128,748 $172,347 $272,734 $358,543
Cost of sales.................... 109,647 151,884 223,740 296,454
---------- ---------- ---------- ----------
Gross profit............... 19,101 20,463 48,994 62,089
---------- ---------- ---------- ----------
Operating expenses:
Research and development....... 7,680 7,168 14,222 14,260
Selling, general and
administrative............... 25,224 23,747 45,581 46,905
Amortization of intangibles.... 1,089 244 2,178 488
Restructuring expenses......... -- 1,384 -- 1,384
---------- ---------- ---------- ----------
Total operating expenses.. 33,993 32,543 61,981 63,037
---------- ---------- ---------- ----------
Income (loss) from operations.... (14,891) (12,080) (12,987) (948)
Interest income, net............. (1,221) 157 (1,960) 493
Other income (expense), net...... 744 89 1,485 (55)
---------- ---------- ---------- ----------
Income (loss) before provision
(benefit) from income taxes.... (15,369) (11,834) (13,462) (510)
Provision (benefit) from income
taxes.......................... (4,611) (3,550) (4,039) (153)
---------- ---------- ---------- ----------
Net income (loss)................ ($10,758) ($8,284) ($9,423) ($357)
========== ========== ========== ==========
Net income (loss) per share:
Basic..................... ($0.30) ($0.24) ($0.27) ($0.01)
Diluted................... ($0.30) ($0.24) ($0.27) ($0.01)
Shares used in per share
calculations:
Basic..................... 35,469 34,991 35,370 34,799
Diluted................... 35,469 34,991 35,370 34,799
The accompanying notes are an integral part of these consolidated condensed
financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED; IN THOUSANDS)
Six Months Ended
June 30,
----------------------
1999 1998
---------- ----------
Cash flows from operating activities:
Net loss............................................. (9,423) ($357)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization..................... 6,301 3,543
Provision for doubtful accounts................... (896) (2,053)
Provision for excess and obsolete inventories..... (14,164) (10,851)
Loss on disposal of fixed assets.................. 5 --
Deferred income taxes............................. (4,004) --
Changes in assets and liabilities:
Trade accounts receivables........................ (24,684) (1,112)
Inventories....................................... 16,553 (103)
Prepaid expenses and other assets................. 4,408 (2,159)
Income taxes receivable........................... 3,044 18,308
Trade accounts payable and other liabilities...... 1,841 1,560
Deferred income on distributor inventories........ (5,075) --
---------- ----------
Net cash provided by (used in) operating
activities.................................... (26,094) 6,776
---------- ----------
Cash flows from investing activities:
Purchases of property and equipment................. (5,824) (9,940)
Liability for purchase of Micronics, net of
net assets acquired............................ -- 10,970
Other equity investments............................ -- (1,150)
Purchases of short-term investments................. 4,950 (1,937)
---------- ----------
Net cash used in investing activities............. (874) (2,057)
---------- ----------
Cash flows from financing activities:
Proceeds from issuance of common stock.............. 1,340 5,146
Repurchases of common stock......................... -- (1)
Proceeds from term loans and revolving credit
facilities...................................... 60,821 54,024
Payments and maturities of term loans and
revolving credit facilities..................... (44,779) (40,253)
Redemption of restricted certificates of deposit.... 750 --
Repayments of capital lease financings.............. (132) (427)
---------- ----------
Net cash provided by financing activities......... 18,000 18,489
---------- ----------
Net increase (decrease) in cash and cash equivalents... (8,968) 23,208
Cash and cash equivalents at beginning of period....... 24,621 85,929
---------- ----------
Cash and cash equivalents at end of period............. 15,653 $109,137
========== ==========
The accompanying notes are an integral part of these consolidated condensed
financial statements.
DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared by the Company in accordance with generally accepted accounting
principles for interim financial information and pursuant to rules and
regulations of the Securities and Exchange Commission. In the opinion of
management, all adjustments (consisting only of normal recurring
adjustments) considered necessary for a fair presentation have been
included. These financial statements should be read in conjunction with
the Company's consolidated financial statements and notes thereto
contained in the Company's Report on Form 10-K (as amended by the
Company's Report on Form 10-K/A) for the fiscal year ended December 31,
1998.
Operating results for the three and six month periods ended June 30,
1999 may not necessarily be indicative of the results to be expected for
any other interim period or for the full year.
2. INVENTORIES
Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market. Inventories consisted of (in thousands):
June 30, December 31,
1999 1998
------------ ------------
Raw materials ............. $18,198 $17,388
Work in process............ 10,074 20,739
Finished goods............. 18,232 10,765
------------ ------------
$46,504 $48,892
============ ============
The Company evaluates its inventory position on a regular basis and as a
result, has determined it has inventory in excess of short term needs as
of June 30, 1999. Management has developed a program to reduce this
inventory to desired levels over the near term; however, it is
reasonably possible that the program will not be wholly successful and
that a material loss could ultimately result on the disposal of this
inventory. No estimate can be made of the range of amounts of such loss.
3. COMPUTATION OF NET INCOME PER SHARE
Basic earnings per share (EPS) is computed as net income 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.
The following is a reconciliation of the numerator (net loss) and
denominator (number of shares) used in the basic and diluted EPS calculation:
(Dollar amounts, in thousands)
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- ---------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
Basic:
Net income (loss).............. ($10,758) ($8,284) ($9,423) ($357)
Average Common
Shares Outstanding........... 35,469 34,991 35,370 34,799
---------- ---------- ---------- ----------
Basic EPS........................ ($0.30) ($0.24) ($0.27) ($0.01)
========== ========== ========== ==========
Diluted:
Net income (loss).............. ($10,758) ($8,284) ($9,423) ($357)
Average Common
Shares Outstanding........... 35,469 34,991 35,370 34,799
Stock options.................. -- -- -- --
---------- ---------- ---------- ----------
Total shares..................... 35,469 34,991 35,370 34,799
Diluted EPS...................... ($0.30) ($0.24) ($0.27) ($0.01)
========== ========== ========== ==========
Common equivalent shares (in thousands) of 1,790 and 2,160 for the three
and six month periods ending June 30, 1999, respectively, and common
equivalent shares of 745 and 1,243 for the three and six month periods
ending June 30, 1998, respectively, have been excluded from the
calculation of dilituve earnings per share as their effect is anti-
dilutive.
4. S3 MERGER
Diamond and S3 Incorporated, a Delaware corporation ("S3"), have
entered into an Agreement and Plan of Merger, dated as of June 21, 1999
(the "Merger Agreement"), whereby a wholly-owned subsidiary of S3
("Merger Sub") will be merged with and into Diamond, with Diamond as
the surviving entity (the "Merger"). As a result of the Merger, the
outstanding shares of Diamond Common Stock will be converted into
shares of S3 Common Stock at an exchange ratio equal to 0.52 share of
S3 Common Stock for each share of Diamond Common Stock. As a result of
the Merger, Diamond will become a wholly-owned subsidiary of S3, and
Diamond's board of directors will consist of the directors of Merger
Sub immediately prior to the effective time of the Merger. The closing
of the Merger is subject to certain conditions, including the approval
of the Common Stock holders of Diamond and S3 and the receipt of
customary antitrust clearance. In July 1999, the waiting period under
the Hart-Scott-Rodino Antitrust Improvements Act expired.
S3 and Diamond entered into a Credit Agreement, dated as of June 10,
1999, and amended on June 14, 1999, pursuant to which S3 made three (3)
separate loans to Diamond in an aggregate amount of $20.0 million. In
connection with these loans, Diamond issued to S3 three (3) warrants to
purchase an aggregate of 4,597,871 shares of Diamond Common Stock at
exercise prices ranging from $4.18 to $4.471875 per share.
Because of Diamond's liquidity position and resulting cash constraints,
which resulted from its working capital requirements and continued
investments in new product lines such as the Rio Internet audio player
and HomeFree line of home networking products, in July 1999, Diamond
assigned its rights to acquire OneStep, LLC to S3, and S3 acquired
OneStep for approximately $10.0 million in cash. OneStep is a software
development company that supplies the Rio Audio Manager for Diamond's
Rio Internet audio players. Under its agreements with S3, Diamond is
currently funding the operating expenses of OneStep, and S3 has
licensed to Diamond's wholly-owned subsidiary, RioPort.com, Inc.,
OneStep's intellectual property. Diamond currently intends to carve
out RioPort as an independently managed company funded by outside
investors, while maintaining a substantial equity position in RioPort.
At the same time as RioPort's planned venture capital financing,
Diamond and S3 intend that S3 will sell OneStep to RioPort in exchange
for cash and shares of RioPort stock.
5. LITIGATION
The Company has been named as a defendant in several putative class
action lawsuits which were filed in June and July of 1996 and June 1997
in the California Superior Court for Santa Clara County and the U.S.
District Court for the Northern District of California. Certain
executive officers and directors of 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.
On August 4, 1999, a purported class action complaint was filed against
the Company and the members of its Board of Directors. The complaint
purports to be brought on behalf of all the stockholders of the
Company. The complaint arises out of the pending merger of the Company
with S3. The complaint alleges that the Company and the members of the
Board of Directors breached their fiduciary duties to the stockholders
by failing to obtain reasonable consideration for the Company's
stockholders in the S3 transaction. The complaint seeks an injunction
against the transaction, rescission of the transaction, compensatory
damages, and other remedies. The defendants have not yet responded to
the complaint. No trial date or other schedule has been established in
this matter.
On April 23, 1999, 3Dfx Interactive, Inc. ("3Dfx") filed a lawsuit
against the Company for breach of contract based upon unpaid invoices
in the amount of $3,895,225. On June 4, 1999 the Company filed an
answer and cross-complaint alleging breach of contract, breach of the
implied covenant of good faith and fair dealing, breach of implied
warranty and negligence. The Company's cross-claim seeks offsets
totaling $4,868,035 for (1) 3Dfx's breach of an agreement to provide
price advantages and other "most favored customer" terms to the Company
and (2) defective 3Dfx product. These damages totally offset the amount
claimed by 3Dfx for unpaid invoices and result in a net claim of
$941,155 by the Company. At the time it filed its complaint, 3Dfx
sought to attach Company assets worth $3,895,225.00. On June 16, 1999
the court issued a right to attach order in the amount of
$2,859,035. The Company thereafter substituted a bond for the
attached property, and all attached assets were released. Although
discovery has commenced, the parties are pursuing a mediation of their
dispute. The Company has amended its cross-complaint to seek an
accounting of 3Dfx's business records to facilitate the determination
of the Company's damages. No trial date has been set.
Sega initiated a claim for arbitration in Tokyo, Japan against the
Company in December 1998. The claim arises out of an agreement entered
into between Sega and the Company in September 1995, in which Sega
agreed to provide the Company with Sega game software that the Company
would bundle with its 3-D graphics board "The Edge." Sega claims that
the Company breached the parties' agreement by failing to pay Sega a
contractual minimum royalty fee for the games as set forth in the
agreement. Sega claims as damages unpaid royalties and pre-judgment
interest of approximately twelve million dollars ($12,000,000). On
May 28, 1999, the Company responded to Sega's claims by filing an
answer in which it denied the material allegations of Sega's claims.
The Company will file a supplemental brief on these issues with the
arbitration panel on or before August 23, 1999. A hearing on the
merits of this action is currently scheduled for September 2, 1999.
The Company contests the material allegations of Sega's claims. In
addition, the Company has pleaded that Sega's failure to provide it
with 3-D optimized game software on a timely basis adversely affected
sales of The Edge. The Company claims that these lost sales and
profits therefrom should provide an offset to Sega's claims in the
arbitration.
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.
The ultimate outcome of the actions described above cannot presently be
determined. Accordingly, no provision for any liability or loss that
may result from adjudication or settlement thereof has been made in the
accompanying financial statements.
On August 2, 1999, the Company and the Recording Industry Association
of America, Inc. (the "RIAA") entered into a settlement, pursuant to
which the lawsuit filed by the RIAA against the Company is to be
dismissed. The Company and the RIAA have announced the mutually
satisfactory resolution of outstanding legal issues. The terms of the
settlement are confidential.
6. COMPREHENSIVE NET 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
three-month and six-month periods ended June 30, 1998 and 1999, there
are no material differences between comprehensive income and net income.
7. 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.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The discussion and analysis below contains trend analysis and other
forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934. Actual results could differ materially from those projected in
the forward-looking statements as a result of the risk factors set forth
under "Certain Factors That May Affect Future Performance" below and
elsewhere in this report.
The following discussion should be read in conjunction with the
Company's consolidated financial statements and the notes thereto. All
references to years represent fiscal years unless otherwise noted.
Overview
Diamond Multimedia Systems, Inc. ("Diamond" or the "Company") designs,
develops, manufactures and markets multimedia and connectivity products
for 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.
S3 Merger
Diamond and S3 Incorporated, a Delaware corporation ("S3"), have
entered into an Agreement and Plan of Merger, dated as of June 21, 1999
(the "Merger Agreement"), whereby a wholly-owned subsidiary of S3
("Merger Sub") will be merged with and into Diamond, with Diamond as
the surviving entity (the "Merger"). As a result of the Merger, the
outstanding shares of Diamond Common Stock will be converted into
shares of S3 Common Stock at an exchange ratio equal to 0.52 share of
S3 Common Stock for each share of Diamond Common Stock. As a result of
the Merger, Diamond will become a wholly-owned subsidiary of S3, and
Diamond's board of directors will consist of the directors of Merger
Sub immediately prior to the effective time of the Merger. The closing
of the Merger is subject to certain conditions, including the approval
of the Common Stock holders of Diamond and S3 and the receipt of
customary antitrust clearance. In July 1999, the waiting period under
the Hart-Scott-Rodino Antitrust Improvements Act expired.
S3 and Diamond entered into a Credit Agreement, dated as of June 10,
1999, and amended on June 14, 1999, pursuant to which S3 made three (3)
separate loans to Diamond in an aggregate amount of $20.0 million. In
connection with these loans, Diamond issued to S3 three (3) warrants to
purchase an aggregate of 4,597,871 shares of Diamond Common Stock at
exercise prices ranging from $4.18 to $4.471875 per share.
Because of Diamond's liquidity position and resulting cash constraints,
which resulted from its working capital requirements and continued
investments in new product lines such as the Rio Internet audio player
and HomeFree line of home networking products, in July 1999, Diamond
assigned its rights to acquire OneStep, LLC to S3, and S3 acquired
OneStep for approximately $10.0 million in cash. OneStep is a software
development company that supplies the Rio Audio Manager for Diamond's
Rio Internet audio players. Under its agreements with S3, Diamond is
currently funding the operating expenses of OneStep, and S3 has
licensed to Diamond's wholly-owned subsidiary, RioPort.com, Inc.,
OneStep's intellectual property. Diamond currently intends to carve
out RioPort as an independently managed company funded by outside
investors, while maintaining a substantial equity position in RioPort.
At the same time as RioPort's planned venture capital financing,
Diamond and S3 intend that S3 will sell OneStep to RioPort in exchange
for cash and shares of RioPort stock.
Net Sales
Net sales for the second quarter of 1999 decreased $43.6 million (25%)
to $128.7 million compared to $172.3 million for the second quarter of
1998. Net sales for the first half of 1999 decreased $85.8 million (24%)
to $272.7 million compared to $358.5 million for the first half of 1998.
The decrease in net sales was primarily attributable to reduced
shipments of the Company's graphics accelerator products. This was
partially offset by increased shipments of sound cards, as well as
revenues from new products such as the Rio portable Internet music
player and the HomeFree line of home networking products.
Net sales were generated internationally as follows:
Three Months Ended Six Months Ended
June 30 June 30
1999 1998 1999 1998
---------- ---------- ---------- ----------
Revenues (in thousands):
North America $79,946 $93,014 $148,059 $195,690
Europe $31,390 $60,562 $91,581 $124,613
Asia and Latin America $17,412 $18,771 $33,094 $38,240
---------- ---------- ---------- ----------
$128,748 $172,347 $272,734 $358,543
Proportions:
North America 62% 54% 54% 54%
Europe 24% 35% 34% 35%
Asia and Latin America 14% 11% 12% 11%
---------- ---------- ---------- ----------
100% 100% 100% 100%
Revenues from graphics accelerators declined in part due to continued
reductions in demand for entertainment specific products. In particular,
the Company is no longer building and selling high performance 3D-only
products. In addition, demand and pricing for graphics accelerators that
combine 2D and 3D display and are targeted specifically for game
enthusiasts declined. While revenues from general purpose, high-
performance graphics products did not change significantly from the
first six months of 1998 to the first six months of 1999, revenue for
low-end graphics accelerators continued to decline significantly as more
of these market requirements were met by the direct installation of
graphics chips onto motherboards.
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. These
Channel Inventory Levels tend toward the low end of the months-of-supply
range when demand is stronger, sales are higher and products are in
short supply. Conversely, when demand is slower, sales are lower and
products are abundant, then Channel Inventory Levels tend toward the
high end of the months-of-supply range. In such situations, the Company
has in the past attempted 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 such 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. In 1998 the Company began to reduce
its Channel Inventory Levels to more desirable levels. While this has
reduced customer credits for returns, price protection and other pricing
discounts, these continue to be significant factors in the Company's
revenue. While the Company believes that its Channel Inventory Levels
for most of its products are appropriate at this time, there are certain
products which currently have a Channel Inventory Level that is higher
than desirable. The Company estimates and accrues for potential price
protection charges on unsold channel inventory. However, there can be no
assurance that these estimates or accruals will be sufficient. Should
the estimates or accruals not be sufficient, additional price protection
charges may be required, the result of which could have a material
adverse effect on operating results during the third quarter of 1999.
Gross Margin
Gross profit for the second quarter of 1999 decreased $1.4 million to
$19.1 million (14.8% of net sales) compared to $20.5 million (11.9% of
net sales) in the second quarter of 1998. Gross profit for the first
half of 1999 decreased $13.1 million to $49.0 million (18.0% of net
sales) compared to $62.1 million (17.3% of net sales) in the first half
of 1998. The increase in gross margin (gross profit as a percent of net
sales) in both the second quarter of 1999 and the first six months of
1999, compared to the second quarter of 1998 and the first six months of
1998, was primarily attributable to a product mix consisting of newer
higher margin products, especially in the market for mainstream and
professional graphics accelerators. This was partially offset by
negative margins on entertainment specific graphics accelerators.
Research and Development
Research and development (R&D) expenses increased $0.5 million
(7.1%) to $7.7 million for the second quarter of 1999, compared to
the second quarter of 1998. Research and development (R&D) expenses
were decreased slightly (0.3%) to $14.2 million for the first half
of 1999, compared to the first half of 1998. As a percentage of
sales, R&D expenses were 6.0% and 4.2% in the second quarter of 1999
and 1998, respectively, and 5.2% and 4.0% for the first half of 1999
and 1998, respectively. The increase in dollars spent for the second
quarter was primarily due to increased development costs for new
product lines such as the Rio line of portable Internet music
players, and other unreleased products. This was partially offset by
expense reduction steps the Company has taken over the past few
quarters, including a reduction in the number of graphics
architectures the Company develops into finished products. The
increases in R&D expenses as a percentage of net sales were
primarily attributable to the decreases in net sales compared to the
corresponding prior year periods.
Selling, General and Administrative
Selling, general and administrative (SG&A) expenses increased $1.5
million (6.2%) to $25.2 million for the second quarter of 1999,
compared to the second quarter of 1998. Selling, general and
administrative (SG&A) expenses decreased $1.3 million (2.8%) to $45.6
million for the first half of 1999, compared to the first half of 1998.
As a percentage of net sales, SG&A expenses were 19.6% and 13.8% in the
second quarter of 1999 and 1998, respectively, and 16.7% and 13.1% in
the first half of 1999 and 1998, respectively. The increases in SG&A in
absolute dollars for the second quarter of 1999, when compared to the
second quarter of 1998, were primarily attributable to legal expenses,
especially those associated with the Company's defense of an attempt by
the recording industry to prevent the sale of its new Rio line of
portable Internet music players. In addition, the Company's
depreciation expense has increased as the result of the installation of
its new enterprise reporting and planning system following the third
quarter of 1998. For the first six months of 1999, SG&A expense
increases in these areas were offset by reductions in infrastructure
costs, and less spending to promote lower margin graphics products. The
increases in SG&A expenses as a percentage of net sales were primarily
attributable to the decreases in net sales compared to the
corresponding prior year periods.
Amortization of Intangible Assets
The Company incurred amortization expense of $1.1 million in the second
quarter of 1999 compared to $0.2 million in the second quarter of 1998.
Amortization expense for the first half of 1999 was $2.2 million
compared to $0.5 million for the first half of 1998. The increases in
amortization expense were due to the amortization of the Company's
purchase of Micronics in June 1998 and DigitalCast in September 1998.
Interest Income and Expense
Interest expense was $1.4 million in the second quarter of 1999 compared
to $0.6 million in the second quarter of 1998. Interest expense was $2.5
million in the first half of 1999 compared to interest expense of $1.1
million in the first half of 1998. Interest income was $0.2 million in
the second quarter of 1999 compared to $0.8 million in the second
quarter of 1998. Interest income was $0.6 million in the first half of
1999 compared to $1.6 million in the first half of 1998. These changes
were caused by lower cash balances available for investment and greater
use of the Company's available lines of credit. In addition, the Company
borrowed funds from a supplier during the second quarter of 1999 and
granted warrants in connection with the loan. This resulted in an
additional interest expense for the quarter.
Other Income and Expense
Net other income was $0.7 million in the second quarter of 1999 compared
to net other expense of $0.1 million during the second quarter of 1998.
Net other income was $1.5 million in the first half of 1999 compared to
net other expense of $0.1 million during the first half of 1998. The
income in the second quarter of 1999 was primarily due to net foreign
exchange gains and a non-recurring gain associated with a prior
acquisition.
Provision for Income Taxes
The Company's effective tax rate in both the first and second quarter of
1999 and the first and second quarter of 1998 was 30%. Differences from
the statutory rate consisted principally of the effect of state income
taxes, federal tax-exempt interest income and the research and
development tax credit.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents decreased by $9.0 million during the first
half of 1999. Operating activities used $26.1 million in cash. The
primary sources of cash were decreases in inventories, prepaid expenses
and other current assets and income tax refunds, as well as depreciation
and amortization. Significant uses of cash include an increase in trade
accounts receivable, reductions to the provisions for excess and
obsolete inventory and a reduction in deferred income on distributor
inventories.
The Company used $0.9 million in cash from investing activities. The
primary investment was the purchase of $5.8 million in fixed assets, due
in part to the Company's continued investment in leveraging its new
enterprise-wide business management, resource planning and decision
support system. The Company converted to this new system in early
October 1998. Net maturities of short-term investments yielded $5.0
million.
Net cash provided by financing activities was $18.0 million. Primary
sources of cash included $60.8 million from term loans and revolving
credit facilities. These proceeds were partially offset by payments and
maturities of term loans and revolving credit facilities of $44.8
million.
At June 30, 1999, the Company had $15.7 million of cash and cash
equivalents and $1.0 million of short-term investments. Further, as of
such date, the Company had short-term lines of credit and bank credit
facilities totaling $61.0 million, of which approximately $1.0 million
was unused and available. At March 31, 1999 and June 30, 1999, the
Company was in default with its loan covenants regarding liquidity. The
Company obtained waivers for this violation as of March 31, 1999 and is
seeking to obtain waivers for this violation as of June 30, 1999.
The Company expects to spend approximately $10 million for capital
equipment in 1999, principally relating to computer and office equipment
and including, in particular, enhancements to its enterprise-wide
business management, resource planning and decision support system.
The Company believes that its cash balances and available credit under
existing bank lines may not be sufficient to meet anticipated operating
and investing requirements for the short term and accordingly, the
Company is exploring various opportunities to obtain additional capital.
There can be no assurance that additional capital beyond the amounts
currently forecasted by the Company will not be required nor that any
such required additional capital will be available on reasonable terms,
if at all, at such time or times as required by the Company.
YEAR 2000 COMPLIANCE
Many existing computer systems and applications, 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, these systems, applications or control devices
could fail or create erroneous results unless corrected so that they can
process data related to the year 2000. Diamond 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. Diamond 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. Diamond
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 of 1998,
Diamond'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 Diamond. These tools have
the added benefit of managing data with dates beyond December 31, 1999
as indicated by the vendors. Diamond continues to test such capabilities
as part of its post-implementation process. This testing was
successfully completed on schedule for all major computer based
applications during the second quarter of 1999. Diamond'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 Diamond in any given year.
Despite Diamond'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 "Diamond's investment in information technology and
telecommunications could negatively affect its operating results."
In addition, even if the internal systems of Diamond are not materially
affected by the year 2000 issue, Diamond could be affected through
disruption in the operation of the enterprises with which Diamond
interacts. Diamond continues to identify significant external agents
such as service providers, vendors, suppliers and customers and attempts
to reasonably determine their ability to manage year 2000 issues.
The total costs associated with year 2000 compliance are not expected to
be material to Diamond's financial position. The most significant cost
was averted by Diamond'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.
Diamond has not attempted to isolate and specifically identify total
expenses associated with this effort. It is not possible for Diamond 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. Those failures could
materially and adversely affect Diamond's results of operations,
liquidity and financial condition. Contingency plans will be developed
if it appears Diamond or its key external agents will not be year 2000
compliant, and if such compliance is expected to have a material adverse
impact on Diamond's operations.
RISK FACTORS AND CERTAIN OTHER FACTORS THAT MAY AFFECT FUTURE
PERFORMANCE
In addition to other information in this Form 10-Q, the following are
important factors that should be considered carefully in evaluating
Diamond and its business.
Diamond and its stockholders face a number of risks related to the S3
merger.
There are a number of specific risks associated with the proposed S3
merger, including the following:
- -- As a result of the merger, each Diamond stockholder will receive 0.52
of a share of S3 common stock for each share of Diamond common stock
held. This exchange ratio is fixed, and as a result, Diamond
stockholders will not be compensated for decreases in the market price
of S3 common stock that could occur before the merger. In addition,
neither S3 nor Diamond can terminate the merger agreement solely
because S3's stock price declines.
- -- S3 and Diamond entered into the merger agreement with the expectation
that the merger will result in benefits to the combined company,
including faster time to market with new products and increased cost
efficiencies. If we are not able to integrate effectively our
technologies, operations and personnel in a timely and efficient
manner, then the benefits of the merger will not be realized. The
difficulties, costs and delays involved in integrating the companies,
which may be substantial, may include (1) distracting management and
other key personnel, particularly senior engineers involved in product
development and product definition, from the business of the combined
company; (2) perceived and potential adverse changes in business focus
or product offerings; (3) potential incompatibility of business
cultures; (4) costs and delays in implementing common systems and
procedures, particularly in integrating different information systems;
and (5) inability to retain and integrate key management, technical,
sales and customer support personnel.
- -- The announcement and consummation of the merger may disrupt Diamond's
relationships with certain suppliers of graphics chips who compete with
S3. If Diamond loses one or more of these suppliers, it may lose
customers that want Diamond's products to contain components from those
suppliers. For example, a significant portion of Diamond's graphics
accelerator boards incorporate graphics chips supplied by NVIDIA
Corporation. NVIDIA is a direct competitor of S3 and may not continue
to supply the combined company with its products. To the extent that
these relationships are terminated or curtailed and Diamond cannot
persuade its existing customers who purchase products containing any of
those suppliers' graphics chips to purchase products containing S3
graphics chips, then Diamond's revenue contribution to the combined
company could be reduced significantly.
- -- The announcement and consummation of the merger is expected to cause
some of S3's add-in card and motherboard customers to end or curtail
their relationships with the combined company. The loss of these
customers of S3 could cause a decline in sales for the combined company
unless new sales by the combined company have an offsetting effect. For
example, Creative Technology Ltd., a competitor of Diamond and
currently a significant customer of S3, has publicly stated that it may
discontinue its relationship with S3 in the fall of 1999. This is
expected because the combined company's products will comprise both
graphics chips and graphics boards. Thus, the combined company will be
competing with many of S3's current customers, which are graphics board
manufacturers. As a result, we expect that sales to some of S3's
existing customers following the merger will be reduced significantly
from prior levels and that these customers will no longer continue to
be significant customers of the combined company.
- -- As a result of the merger, the combined company will become
significantly dependent on S3's graphics chip design and development
capabilities and significantly dependent on Diamond's graphics board
design, manufacturing and marketing capabilities. This will occur
because both companies will be more restricted in their ability to
select and use products produced by either company's competitors prior
to the merger. If either S3's graphics chips or Diamond's graphics
boards fail to meet the volume, timing, quality and performance
requirements of the market and the combined company's customers, the
combined company's relationship with those customers could be hurt.
This could negatively affect the combined company's financial
performance.
- -- Upon consummation of the merger, Diamond stockholders will become S3
stockholders. There are important differences between the rights of
stockholders of Diamond and stockholders of S3. For example, S3 has
adopted a stockholder rights plan that may discourage certain types of
transactions involving an actual or threatened change of control of S3
even though a majority of the stockholders believe the change of
control to be in their best interest. Diamond has no such plan.
- -- Diamond and S3 estimate that S3's acquisition costs related to the
merger will result in aggregate costs and expenses of approximately
$13.8 million. These expenses will prevent the combined company from
spending those amounts on other, possibly more productive, uses.
- -- The directors and officers of Diamond participate in arrangements and
have continuing indemnification against liabilities that provide them
with interests in the merger that are different from, or in addition
to, the stockholders of Diamond. In particular, all vice presidents
and executive officers of Diamond have agreements with Diamond
entitling them to severance benefits and accelerated vesting of up to
one year of their options to purchase shares of Diamond common stock if
their employment relationship is terminated following the merger. The
personal benefits to be received in the merger by William J. Schroeder,
Diamond's President and Chief Executive Officer, and certain of
Diamond's directors, including Gregorio Reyes and James T. Schraith,
may raise conflicts of interest for each of these individuals because
the receipt of these benefits may favorably influence their support of
the merger. In particular, all Diamond options granted to the officers,
directors and employees of Diamond will be assumed by S3 and thereafter
entitle the holders of those options to acquire S3 common stock,
assuming their continuous status as an officer, director or employee.
Messrs. Schroeder, Reyes and Schraith will be nominated to serve as
directors on the S3 board of directors and accordingly, the options of
Messrs. Reyes and Schraith held under the Diamond Director Stock Option
Plan will continue to vest.
- -- If the merger is not completed for any reason, Diamond may be subject
to a number of material risks, including the following: (1) Diamond may
be required to pay S3 a termination fee of $5.0 million; (2) Diamond
will owe S3 $20.0 million under the credit agreement with S3; (3) the
price of Diamond common stock may decline to the extent that the
current market price of Diamond common stock reflects a market
assumption that the merger will be completed; and (4) costs related to
the merger, such as legal, accounting and financial advisor fees, must
be paid even if the merger is not completed.
- -- Diamond's customers may, in response to the announcement of the merger,
delay or defer purchasing decisions. Any delay or deferral in
purchasing decisions by Diamond customers could materially and
adversely affect Diamond's business, regardless of whether the merger
is ultimately completed. Similarly, current and prospective Diamond
employees may experience uncertainty about their future role with S3
until S3's strategies with regard to Diamond are announced or executed.
This may adversely affect Diamond's ability to attract and retain key
management, marketing and technical personnel.
- -- If the merger is terminated and Diamond's board of directors determines
to seek another merger or business combination, Diamond may be unable
to find a partner willing to pay an equivalent or more attractive price
than the price proposed to be paid in the merger. In addition, while
the merger agreement is in effect and subject to certain exceptions,
Diamond is prohibited from soliciting, initiating or inducing or
entering into certain extraordinary transactions, such as a merger,
sale of assets or other business combination, with any party other than
S3. Also, if the merger agreement is terminated, because of the
warrants to purchase Diamond common stock granted to S3, Diamond may
not be able to account for future transactions as a "pooling of
interests."
- -- Diamond's cash balances and available credit under existing bank lines
may not be sufficient to meet anticipated operating and investing
requirements for the short term and, if the merger is not completed,
Diamond will have to seek additional capital.
Diamond's operating results are subject to fluctuations caused by many
factors, many of which are beyond its control.
Diamond'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 Diamond has identified which may affect the future
performance of Diamond.
Diamond develops products in the highly competitive PC multimedia, and
communications markets, including the graphics, video, sound, portable
Internet audio player, modem, and home networking areas. These products
are 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
and pricing actions by competitors can materially and adversely affect
Diamond's revenues and gross margins.
Diamond sells its products to retail channel 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, VARs, OEM customers (customers which use Diamond'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 Internet-based e-commerce.
Reliance on indirect channels of distribution means that Diamond
typically has little or no direct visibility into end-user customer
demand. OEM customers tend to provide Diamond with forecasts for product
requirements, but actual order lead times remain less than 90 days.
Retail channel 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, future operating results
are dependent on continued sales to customers where the vast majority of
the normal volume of orders are placed with Diamond within the same
calendar quarter as, and frequently within a few days of, the customer's
requested date of shipment by Diamond.
Because the lead times of firm orders are typically short, Diamond does
not have the ability to predict future operating results with any
certainty. Therefore, sudden changes that are out of the control of
Diamond such as general economic conditions and the actions or inaction
of competitors, customers, and third-party vendors of operating system
software and microprocessors can have and have had material adverse
effects on Diamond's performance.
Other factors which may materially and adversely affect Diamond's future
performance include:
- -- the management of growth and change;
- -- rapid declines in the price of components used by Diamond;
- -- latent defects that can exist in Diamond'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 Diamond's common stock. Due to these
factors, it is likely that the operating results of Diamond in some
future quarter or quarters will fall below the expectations of
securities analysts and investors. In such an event, the trading price
of Diamond's common stock would likely decline.
Diamonds revenues are difficult to forecast, subject to wide
fluctuations and dependent on orders received and shipped during a
fiscal 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, Diamond has
historically operated with a relatively small backlog. Moreover, Diamond
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 Diamond's emphasis on
minimizing inventory levels, has resulted in customers placing orders
with relatively short delivery schedules and increased demand on Diamond
to carry inventory for its customer base, particularly for large OEM
customers, or OEM Hubs. This has the effect of increasing short lead-
time orders as a portion of Diamond's business and reducing Diamond's
ability to accurately forecast net sales. Because retail and retail
distribution customers' orders are more difficult to predict, Diamond
can offer 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
Diamond does not achieve a sufficient level of retail and retail
distribution orders in a particular quarter, Diamond's revenues and
operating results would be materially and 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, Diamond's customers may choose to draw down their
inventory levels thereby reducing Diamond'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 transition of mainstream PC graphics subsystem architectures from
2D graphics and the PCI bus to 3D graphics and the accelerated graphics
port, or AGP, which began in 1997 and continued through 1998, controller
and memory chip selection and the timely introduction of new products
were critical factors. Diamond 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 Diamond's remaining PCI-
based and SGRAM-based graphics inventory and by significant price
protection claims associated with those price declines. Due to the
continual evolution of the types of products sold by Diamond, it is
probable that transitions such as these will continue to have material
and possibly adverse effects on Diamond's operating results.
Because a substantial portion of Diamond's net sales for a quarter may
be generated in the last month or weeks of a quarter, any shortfall in
net sales from Diamond's expectations would negatively impact operating
results.
As is common in the personal computer industry, a disproportionate
percentage of Diamond's net sales in any quarter is 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, Diamond's net sales
for the [second quarter of 1998] were lower than expected because of
sudden order cancellations of the Monster 3D II product during the final
week of the quarter. In addition, from time to time, a significant
portion of Diamond'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, Diamond 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 Diamond's operating results and cash balances in a
magnified way due to Diamond'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, Diamond 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. Diamond can offer no assurance that such
an occurrence will not adversely impact its operating results.
Recently, Diamond implemented 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, Diamond 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.
Diamond's gross margins may be adversely affected by declining selling
prices resulting from intense price competition, component pricing and
other factors.
Diamond'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 Diamond's average selling prices
will decline, and that Diamond's net sales and margins may decline in
the future, from the levels experienced to date. See also ["Due to the
short product life cycles of Diamond's products, Diamond must
continuously develop, introduce and market new products in a timely
manner and manage product transitions effectively."] Diamond's gross
margins may also be adversely affected by shortages of, or higher prices
for, key components for Diamond'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, memory 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, Diamond's ability 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 Diamond.
In addition, Diamond'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 Diamond, 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 Diamond 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
customer. Diamond experienced declining prices and reduced margins in
these circumstances 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
memory, 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
Diamond's gross margins due to higher unit costs, and a decrease in the
supply of such semiconductor components may adversely impact Diamond's
net sales due to lower unit shipments.
Diamond's operating results are affected by industry seasonality.
Diamond believes that, due to industry seasonality, demand for its
products is strongest during the six-month period September through
February of each year and is generally slower in the six-month period
from March through August. This seasonality might become more pronounced
and material in the future to the extent that a greater proportion of
Diamond's sales consist of sales into the retail/mass merchant channel,
that PCs become more consumer-oriented or entertainment-driven products,
or that Diamond's net revenue becomes increasingly based on
entertainment-related products. Also, to the extent Diamond is
successful in expanding its European operations, it may experience
relatively weaker demand in third calendar quarters due to historically
weak summer sales in Europe.
Diamond faces significant capital needs.
There can be no assurance that additional capital beyond the amounts
currently forecasted by Diamond will not be required or that any
required additional capital will be available on reasonable terms, if at
all, at the time or times required by Diamond. If the merger with S3 is
not consummated, Diamond believes that its cash balances and available
credit under existing bank lines may not be sufficient to meet
anticipated operating and investing requirements for the short term and
accordingly, Diamond is exploring various opportunities to obtain
additional capital. Any shortfall in capital resources compared to
Diamond's level of operations or any inability to secure additional
capital as needed could impair Diamond's ability to finance inventory,
accounts receivable and other operational needs. These capital
limitations could also impair Diamond's ability to invest in research
and development, improve customer service and support, deploy
information technology systems, and expand manufacturing and other
operations, including investments in Diamond's new business areas.
Failure to keep pace with competitive requirements in any of these areas
could materially and adversely affect Diamond'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.
Diamond has experienced significant expansion in its operations which
strains its resources and presents numerous challenges.
In recent years, Diamond 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, including, among others:
- -- securing adequate financial resources to successfully integrate and
manage the changing 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 on-line 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.
Managing each of these requirements poses significant challenges.
In the fourth quarter of 1998, for example, Diamond commenced
manufacturing and shipping its first finished consumer electronics
product, Rio, a portable Internet music player. Also during the fourth
quarter of 1998, Diamond commenced manufacturing and shipping the
HomeFree wireless line of home networking products. Diamond commenced
manufacturing and shipping the HomeFree phoneline-based home networking
products in January 1999. These products pose new design, manufacturing,
marketing and customer support issues to Diamond and Diamond cannot
assure you that it can successfully meet these challenges, generate
customer demand for such products or satisfy customer demand and support
needs for the products. In addition, the cost associated with meeting
these challenges and satisfying demand may have a material adverse
impact on Diamond's operating results in future periods.
Diamond's future operating results will depend in large measure on its
success in accomplishing a number of objectives, including:
- -- 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.
Due to the short product life cycles of Diamond's product's, Diamond
must continuously develop, introduce and market new products in a timely
manner and manage product transitions effectively.
The market for Diamond'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. Diamond 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, Diamond
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
Diamond's existing products. The success of new product introductions
depends on various factors, some of which are outside Diamond's direct
control. These 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;
- -- Diamond's 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 Diamond'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. Diamond 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 Diamond's PCI-based and
SGRAM-based graphics inventory and the inventory of such products in the
distribution channel. As a result, Diamond's net sales and gross margins
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. Diamond
currently faces similar standards-setting issues in the areas of home
networking, broadband modems (both DSL and cable), video and Internet
audio. Diamond cannot assure you that it will select the proper chips,
software and protocols to implement and support its efforts in
developing new products or targeting new markets or that it will execute
its strategies in a timely manner.
Each new product cycle presents new opportunities for current or
prospective competitors of Diamond to gain a product advantage or
increase their market share. If Diamond does not successfully introduce
new products within a given product cycle, Diamond's sales will be
adversely affected for that cycle and possibly for subsequent cycles.
Any such failure could also impair Diamond'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 Diamond's
products, Diamond 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 those 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 Diamond 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 and fourth quarters of 1998. Diamond
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 Diamond's operating results in 1998 and
the first quarter of 1999 were material and adverse. Any similar
occurrence in the future could have a material effect on operating
results in such future operating periods.
The introduction of and transition to new personal computer operating
systems and other applications can negatively impact demand in the PC
industry and may strain Diamond's research and development efforts.
The PC industry is 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. Diamond believes that
this forward shift in time of a significant number of computer
purchasers adversely affected its revenues 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,
or 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 Diamond. 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 Diamond'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 Diamond'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 Diamond's
software, graphics accelerator and modem products to Windows 95, Diamond
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 Diamond, Diamond 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 Diamond 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.
Diamond depends on a limited number of third party software developers
and publishers that develop graphics software products that will operate
with and fully utilize the capabilities of Diamond's products to
generate demand for Diamond's products.
Diamond'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 design and content creation markets. Diamond
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. Diamond 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 a
significant factor in the sale of 3D graphics hardware to the PC-based
NT workstation market. Diamond depends on independent software
application developers and publishers to create, produce and market
software entertainment titles and professional graphics applications
that will operate with Diamond'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. Diamond cannot assure you that it 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 Diamond's 3D graphics and audio platforms.
Further, in the case of Diamond's entertainment 3D products, Diamond
cannot assure you 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
Diamond's entertainment 3D products such as the Stealth III's (based on
S3's Savage 4) ability to support texture compression, could create the
impression that Diamond's products offer less compelling performance
over competing 3D graphics accelerators or 3D games platforms, such as
TV games consoles. This could result in the loss of PC graphics market
share to competitors or might 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 Diamond 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.
If undetected defects are discovered in Diamond's products, Diamond's
reputation could be seriously harmed and Diamond could be subject to
product returns and delayed market acceptance of its products.
Product components may contain undetected errors or "bugs" when first
supplied that, despite testing by Diamond, are discovered only after
certain of Diamond's products have been installed and used by customers.
There can be no assurance that errors will not be found in Diamond's
products due to errors in the products' components, or that any of these
errors will not impair the market acceptance of these products or
require significant product recalls. Problems encountered by customers
or product recalls could materially and adversely affect Diamond's
business, financial condition and results of operations. Further,
Diamond continues to upgrade the firmware, software drivers and software
utilities that are incorporated into or included with its hardware
products. Diamond's software products, and its hardware products
incorporating that 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 Diamond'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. Diamond
generally provides a five-year warranty for its products and, in
general, Diamond'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
Diamond, 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. Any of these losses or delays would
likely have a material adverse effect on Diamond'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 Diamond's
software products to maintain compatibility with such new versions or
upgrades. Diamond cannot assure you that it will be successful in
developing new versions or enhancements to its software or that it will
not experience delays in the upgrade of its software products. In the
event that Diamond experiences delays or is unable to maintain
compatibility with operating systems and independent software vendor
titles or applications, Diamond's business, financial condition and
results of operations could be materially and adversely affected.
Market anticipation of new products, new technologies or lower prices
could negatively affect Diamond's operating results.
Since the environment in which Diamond operates is characterized by
rapid new product and technology introductions and generally declining
prices for existing products, Diamond's customers may from time to time
postpone purchases in anticipation of these new product introductions or
lower prices. If these 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
Diamond'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 Diamond, 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 Camino chipset supporting the 4x AGP
architecture, 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. Finally, Year 2000 issues anticipated by or faced by Diamond's
direct customers or indirect end customers might slow the overall market
for PCs or the upgrade of PCs either in late 1999 or early in the year
2000.
The potential negative impact on Diamond's operating results as a result
of customer decisions to postpone purchases in favor of new and
"publicized" technologies, including Diamond'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, Diamond 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, Diamond's
operating results could be adversely affected if Diamond makes poor
selections of chip architectures or chip suppliers to pursue 3D
graphics, video, audio, Internet music, home networking or broadband
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 these components.
If Diamond or any of its competitors were to announce a product that the
market viewed as having more desirable features or pricing than
Diamond's existing products, demand for Diamond's existing products
could be curtailed, even though the new product is not yet available.
For example, in the second quarter of 1998, Diamond'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 Diamond's SGRAM based graphics products and
materially and adversely affected Diamond's operating results for the
second and third quarters of 1998. Similar results may occur during 1999
as the market anticipates new low-cost 32-megabyte and new high-
performance 64-megabyte graphics accelerators. Similarly, if Diamond's
customers anticipate that Diamond may reduce its prices in the near
term, they might postpone their purchases until such price reductions
are effected, reducing Diamond'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 Diamond's operating results in the short term. This factor
constitutes an exceptionally difficult-to- manage characteristic of
Diamond's graphics business due to the rapid six-month product cycles
that typify the current 3D graphics market.
Diamond depends on a limited number of suppliers from whom Diamond does
not have a guarantee of adequate supplies, increasing the risk that a
loss of or problems with a single supplier could result in impaired
margins, reduced production volumes, strained customer relations and
loss of business.
Diamond is dependent on sole or limited source suppliers for certain key
components used in its products, particularly chipsets and software that
provide the following:
- -- graphics;
- -- digital video;
- -- DVD;
- -- Television;
- -- Internet music;
- -- sound or other multimedia functions;
- -- random access memory (including DRAM, RDRAM, SDRAM, SGRAM and flash)
chips; and
- -- analog modem, softmodem, and broadband modem 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 Diamond may experience constraints in the
supply of high-performance SDRAMs and flash memory and new technology,
high-performance 3D graphics chips for the foreseeable future,
particularly in the newest "tight geometry" technologies (e.g., 0.18
microns). There can be no assurances that Diamond can obtain adequate
supplies of any components, or that these shortages or the costs of
these components will not adversely affect future operating results.
Diamond'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 Diamond's products in general. Although Diamond
maintains ongoing efforts to obtain required supplies of components,
including working closely with vendors and periodically qualifying
alternative components for inclusion in Diamond's products, component
shortages continue to exist from time to time, and Diamond cannot assure
you that it can continue to obtain adequate supplies or obtain these
supplies at their historical or competitive cost levels. Further,
Diamond has as an objective to reduce the number of chip architecture
suppliers with which it works, as for example is evidenced by its
proposed merger with S3 Corporation, potentially raising "single-source"
supply risks. Conversely, in its attempt to counter actual or perceived
component shortages, Diamond 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
Diamond'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 Diamond's gross
margin and profitability. Such a condition existed in the first and
second quarters of 1998, and Diamond's perception of component shortages
caused Diamond 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
Diamond or its competitors may trigger channel price protection charges,
further reducing Diamond'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 Diamond's
competitors, then these actions could enable competitors of Diamond to
enjoy a cost advantage vis-a-vis Diamond, and any resulting price
reduction for such competitors' products could force Diamond to reduce
its prices, thereby depressing Diamond's net sales and gross margins in
one or more operating periods.
During periods of component oversupply and associated price deflation,
customers of Diamond, particularly those comprising channels that do not
receive price protection from Diamond, may seek to draw down the
inventory that they hold since such inventory likely would bear a price
deflation risk. As a consequence, Diamond 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,
Diamond 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. Diamond experienced
such a situation in the second half of 1997 and in the second half of
1998 as Diamond experienced a shortage of various components,
restricting Diamond's ability to manufacture certain products in
sufficient quantities or in a linear fashion to meet market demand. In
addition, Diamond believes that in the near term Diamond may continue to
be subjected to restricted supply and increasing prices on certain
semiconductor components including newly introduced graphics controllers
and high-speed random access memories. The inability of Diamond to
obtain product components at their historical or planned cost levels,
resulting in Diamond being forced to pay higher prices to achieve timely
delivery, would directly affect the cost of Diamond's products and could
materially and adversely affect Diamond's gross margin. Diamond cannot
assure you that it will be able to obtain adequate supplies of
components or that such shortages or the costs of these components will
not adversely impact Diamond's future operating results. Conversely,
Diamond cannot assure you that it 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
Diamond's Monster 3D II product line, based on 3Dfx Interactive's Voodoo
2 chipset.
Diamond depends on third parties for the manufacture of its products.
Diamond relies on independent surface mount technology, or SMT,
subcontractors to manufacture, assemble or test Diamond's board level
products, as well as its first "finished" consumer electronics product,
Rio, an Internet music player. Diamond 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 Diamond's subcontractors could
stop supplying the services, products or components at any time with
limited or no penalty. In the event that it becomes necessary for
Diamond to replace a key subcontractor, Diamond could incur significant
manufacturing set-up costs and delays. Diamond cannot assure you that it
would be able to find suitable replacement subcontractors. Diamond'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. Diamond'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 Diamond's subcontractors
are located in international locations that, while offering low labor
costs, may present heightened process control, quality control,
political, infrastructure, transportation, delivery delay, in-transit
inventory, tariff, regulatory, legal, import, export, economic or supply
chain management risks.
Diamond depends on the personal computer and graphics accelerator markets,
which are rapidly changing, highly cyclical and vulnerable to sharp
changes in demand.
Sales of graphics and video accelerator subsystems accounted for greater
than 77% and 75% of Diamond's net sales in 1998 and 1997, respectively,
and 76% in the first half of 1999. Although Diamond has introduced
audio subsystems, has entered the PC modem and home networking markets,
and has entered into the PC consumer electronics market with its Rio
Internet music player, graphics and video accelerator subsystems,
particularly after the proposed merger with S3 Corporation, are expected
to continue to account for a majority of Diamond'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 core logic chipsets and
motherboards or otherwise, could materially and adversely affect
Diamond's sales and operating results.
The capabilities of Diamond's products either are being or may in the
future be provided by personal computer components and operating systems
that are not sold by Diamond, thus potentially reducing demand for
Diamond's products.
Diamond'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 that functionality is typically reduced by means
of large scale integration into semiconductor chips, which can be
subsequently incorporated onto personal computer motherboards. While
Diamond expects that this migration will not occur in a substantial way
with advanced 3D graphics or Intel's accelerated graphics port, or AGP,
in the near term due to the new, rapidly changing technologies in these
areas, Diamond recognizes that the migration could occur with respect to
the functionality provided by some of Diamond's current products, as
well as with 3D graphics and the AGP bus over the longer term. While
Diamond 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, home networking, and Internet connectivity, Diamond cannot
assure you 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 Diamond's products. 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 graphics and digital video content, including games and
entertainment, broadcast digital video, desktop video conferencing, and
digital video over the Internet. This will be at least in part dependent
on the availability of robust broadband communications to the home.
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 beyond the control of
Diamond.
Diamond 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 that most current personal computers can be upgraded.
These sealed computers may contain a systems board that could include
CPU, system memory, graphics, audio, and connectivity functionality on a
single board. Diamond 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, Diamond cannot assure you that a significant market
will exist for low-cost fixed system boards or that the acquisition of
Micronics will enable Diamond to successfully compete in such an
emerging market or in the current or future motherboard markets.
Recent consolidation in the graphics accelerator industry creates numerous
risks for Diamond on a stand-alone basis.
Until the announcement of the agreement and plan of merger with S3,
Diamond had pursued a strategy of "silicon agility," which entailed
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
Diamond is offering leading edge technology in each product line at
prices with which Diamond 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 Diamond, vertical integration
acquisitions restrict the choices of chipset suppliers available to
Diamond and thereby may reduce the likelihood that Diamond will have
access to leading edge technology at prices which allow Diamond to
compete with vertically integrated competitors such as ATI Technologies
Inc., Matrox Graphics Inc., and 3Com Corporation. Diamond is currently
proposing to merge with S3 Corporation in part to ensure that it has
access to proprietary graphics and video silicon controller technology.
Diamond operates in intensely and increasingly competitive markets and
some of its competitors have greater resources with which to compete.
The market for Diamond's products is highly competitive. Diamond
competes directly against a large number of suppliers of multimedia and
connectivity products for the PC such as Matrox Graphics Inc., 3Dfx
Interactive Inc., 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 Diamond's products. In
certain markets where Diamond is a relatively new entrant, such as
broadband modems, home networking, and consumer electronics Internet
music players, Diamond may face dominant competitors including 3Com
(home networking and modems), Creative Technologies, Inc. (sound cards,
modems and Internet music players), Intel (home networking) and Sony
Corp. (consumer electronic music players). In addition, Diamond'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, chipset or motherboard markets)
emerge as competitors across broader or more integrated product
categories.
In addition, manufacturers of chipsets or other components used in
Diamond's products could become future competitors of Diamond to the
extent that these 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 Diamond. Also, certain of Diamond's current and potential
competitors have significantly greater market presence, name recognition
and financial and technical resources relative to Diamond, and many have
long- standing market positions and established brand names in their
respective markets. In addition, certain of Diamond'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 employee
training funds. Many of Diamond's current and potential competitors also
design and manufacture their own graphics, video, sound, modem, home
networking, or other multimedia or connectivity chipsets. The captive
semiconductor operations of certain of Diamond'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. These risks would become all the
more significant in the event that the proposed merger with S3 is not
consummated.
Diamond 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 Diamond's products or
otherwise adversely affect the market for Diamond's products. To the
extent that semiconductor availability is relatively robust and software
drivers and reference hardware designs from multimedia and connectivity
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 Diamond. Diamond cannot assure you that it
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 Diamond's technology, markets and products
continue to evolve and mature.
Diamond significantly depends on its network of distributors and its
retail chain, VAR and OEM customers.
Diamond sells its products through a network of domestic and
international distributors, and directly to major retailers/mass
merchants, VARs and OEM customers. Diamond'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 Internet electronic commerce on the worldwide web. The loss of, or
reduction in, sales to certain of Diamond's key customers as a result of
changing market conditions, competition, or customer credit problems
could have a material adverse effect on Diamond'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 Diamond in ways not yet known.
For example, the rapid emergence of Internet-based e-commerce is putting
substantial strain on some of Diamond's traditional channels, and
Diamond has invested substantial capital and management resources in
developing its own Internet and EDI e-commerce capabilities. Moreover,
additions to or changes in the types of products Diamond sells, such as
the introduction of professional-grade products or the migration toward
more communications-centric products, such as home networking and
broadband modems, may require specialized value-added reseller channels,
relations with which Diamond has only begun to establish.
Inventory levels of Diamond's products in the two-tier distribution
channels used by Diamond, or 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 and components
are in short supply. Conversely, when demand is slower, sales are lower
and products and components are abundant, then channel inventory levels
tend toward the high end of the months-of-supply range. Frequently, in
these situations, Diamond attempts to ensure that distributors devote
their working capital, sales and logistics resources to Diamond's
products to a greater degree than to those of competitors. Similarly,
Diamond'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, Diamond, 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 Diamond
reduced channel inventory levels as part of its new short-cycle
inventory model. While this is expected to reduce Diamond'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 Diamond
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. Diamond accrues
for potential price protection charges on unsold channel inventory.
However, Diamond cannot assure your that any estimates, reserves or
accruals will be sufficient or that any future price reductions would
not materially and adversely affect operating results.
Diamond is subject to risks relating to product returns and price
protection.
Diamond frequently grants limited rights to customers to return certain
unsold inventories of Diamond's products in exchange for new purchases,
or Stock Rotation, as well as price protection on unsold inventory.
Moreover, certain of Diamond's retail customers will readily accept
returned products from their own retail customers, and these returned
products are, in turn, returned to Diamond for credit. Diamond estimates
returns and potential price protection on unsold channel inventory.
Diamond 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 an estimated four weeks of demand. Diamond 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, Diamond experienced significant price and revenue erosion and
associated price protection on its Monster 3D II product line in the
third and fourth quarters of 1998 as demand for that class of product
declined and market prices also declined significantly. Diamond may be
faced with further significant price protection charges as Diamond and
its competitors move to reduce channel inventory levels of current
products as new product introductions are made, such as Diamond's new
Rio PMP500. However, Diamond cannot assure you 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, price
protection, or consumer end user rebates, particularly in light of the
rapid product obsolescence which often occurs during product
transitions. The short product life cycles of Diamond's products, the
evolving markets for new multimedia and connectivity technologies such
as home networking, cable or xDSL modems, portable digital music players
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
Diamond 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 Diamond's financial performance. In addition, Diamond
cannot assure you that new product introductions by competitors,
particularly in the rapidly changing market for Internet appliances, or
other market factors, such as the integration of graphics and video
acceleration into core logic chipsets or onto system motherboards, will
not require Diamond 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 Diamond's gross margins.
Furthermore, the markets that Diamond 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. These 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 Diamond sells
incorporate advanced computer technology, Diamond expects that end-user
customer returns, including warranty returns, will be a continuing
negative attribute of supplying to the PC installed-base upgrade market.
Diamond cannot assure you that it 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.
Diamond is subject to numerous risks relating to OEM Customers.
Diamond currently has a limited number of tier-1 OEM customers. While
Diamond is seeking to increase its sales to the leading tier-1 OEMs,
certain OEMs maintain internal add-in subsystem design and manufacturing
capabilities or have long-standing relationships with competitors of
Diamond, and Diamond cannot assure you that it 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 Diamond cannot assure you that it 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 Diamond'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. These hubs represent a cash drain on Diamond 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.
Diamond's contractual relationships with Dell, Micron and Compaq
regarding such hubs may represent product obsolescence and inventory
write-off risks.
Diamond'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 Diamond's sales
to OEMs may result in an increase in the proportion of Diamond's revenue
that is generated by lower-selling-price and lower-gross-margin
products, particularly with respect to Diamond's home networking and
modem products, which could adversely affect future gross margins and
operating results of Diamond.
The markets in which Diamond operates are subject to rapid technological
change and product obsolescence, and if Diamond does not accurately
forecast customer demand and develop, market and introduce products in a
timely manner, its business would be seriously harmed.
The markets for Diamond'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 Internet music secure
transmission techniques and navigation technologies are still being
refined. Product life cycles in Diamond's markets frequently range from
six to twelve months. Diamond'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 Diamond 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 Diamond's customers are not the final end customers.
Moreover, whenever Diamond 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, Diamond
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. Diamond, 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 Diamond's on
hand inventory. A similar phenomenon occurred in the third and fourth
quarters of 1998 relative to Diamond's Monster 3D II product line based
on 3Dfx Interactive's Voodoo 2 chipset.
Diamond is subject to a number of risks related to its international
operations and sales to international markets.
Diamond's international sales are subject to a number of risks generally
associated with international business operations, including:
- -- the effect on demand for Diamond'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
Diamond'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 Diamond's
telecommunications products and securing the necessary governmental
approvals for shipment to various countries.
Diamond's international sales can also be affected if inventory sold by
Diamond 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. Diamond 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 Diamond generally has less visibility on how this held
inventory might affect future orders to and sales by Diamond. In the
event that international OEMs or distributors change their desired
inventory levels, Diamond cannot assure you that net sales to such
customers will not decline at that time or in future periods, or that
Diamond will not incur price protection charges with respect to those
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 Diamond's products and other products
necessary for those customers to sell complete products. While Asian
markets have begun to recover, Diamond 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.
Diamond's investment in information technology and telecommunications
systems could negatively affect its operating results in a given period,
and represents a large capital commitment that may negatively impact
its cash flow.
Diamond 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 and to conduct electronic
business transactions with its commercial customers (EDI) and its
consumer customers (Internet e-commerce). 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,
or IT, network and telecommunications equipment and IT applications. As
part of this program to install IT systems throughout Diamond and
attached to the Internet, management has begun installation of an
enhanced enterprise-wide business management, resource planning and
decision support application. Further, in order to more effectively
manage Diamond's business and avert Year 2000 issues, Diamond 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 third quarter of 1999.
Associated with this, Diamond is implementing e-commerce, product data
management and customer support system upgrades. These efforts are
expected to comprise a further substantial investment of capital,
expenses and management resources by Diamond during the second half of
1999.
Diamond may encounter year 2000 compliance problems involving business
and administrative systems, which could negatively affect its
operations and financial results.
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, these systems, applications or control devices
could fail or create erroneous results unless corrected so that they can
process data related to the year 2000. Diamond 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. Diamond 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. Diamond
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 of 1998,
Diamond'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 Diamond. These tools have
the added benefit of managing data with dates beyond December 31, 1999
as indicated by the vendors. Diamond continues to test such capabilities
as part of its post-implementation process. This testing was
successfully completed on schedule for all major computer based
applications during the second quarter of 1999. Diamond'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 Diamond in any given year.
Despite Diamond'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 "Diamond's investment in information technology and
telecommunications could negatively affect its operating results."
In addition, even if the internal systems of Diamond are not materially
affected by the year 2000 issue, Diamond could be affected through
disruption in the operation of the enterprises with which Diamond
interacts. Diamond continues to identify significant external agents
such as service providers, vendors, suppliers and customers and attempts
to reasonably determine their ability to manage year 2000 issues.
The total costs associated with year 2000 compliance are not expected to
be material to Diamond's financial position. The most significant cost
was averted by Diamond'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.
Diamond has not attempted to isolate and specifically identify total
expenses associated with this effort. It is not possible for Diamond 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. Those failures could
materially and adversely affect Diamond's results of operations,
liquidity and financial condition. Contingency plans will be developed
if it appears Diamond or its key external agents will not be year 2000
compliant, and if such compliance is expected to have a material adverse
impact on Diamond's operations.
Diamond relies on intellectual property and other proprietary
information that may not be adequately protected and that may be
expensive to protect.
While Diamond had 18 issued U.S. Patents and 19 pending U.S. Patent
Applications at March 31, 1999, 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. Diamond
cannot assure you that its measures to protect its proprietary rights
will deter or prevent unauthorized use of Diamond's technology, brand or
other proprietary or intellectual property. In addition, the laws of
certain foreign countries may not protect Diamond's proprietary rights
to the same extent as do the laws of the United States or the EC. As is
typical in its industry, Diamond from time to time is subject to legal
claims asserting that Diamond has violated the proprietary rights of
third parties. In the event that a third party was to sustain a valid
claim against Diamond, and any required licenses were not available on
commercially reasonable terms, Diamond's operating results could be
materially and adversely affected. Litigation, which could result in
substantial cost and diversion of the resources of Diamond, may also be
necessary to enforce proprietary rights of Diamond or to defend Diamond
against claimed infringement of the proprietary rights of others.
Diamond's stock price may be volatile.
The trading price of Diamond'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 Diamond or its
competitors, general conditions in the markets for Diamond'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, Diamond 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 Diamond's Common stock.
Diamond may not be able to hire, motivate and retain key personnel.
Diamond'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 these
personnel is intense, particularly in the San Jose, California area, or
the Silicon Valley. There can be no assurance that Diamond 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 Diamond.
The salary, performance bonus and stock option packages necessary to
recruit or retain key personnel, particularly in Silicon Valley, may
significantly increase Diamond's expense levels or result in dilution to
Diamond's earnings per share. Diamond does not carry "key person" life
insurance on any of its employees.
Diamond is a party to several legal proceedings, including actions
involving allegations of securities violations.
Diamond has been named as a defendant in several putative class action
lawsuits which were filed in June and July of 1996 and in June 1997 in
the California Superior Court for Santa Clara County and the U.S.
District Court for the Northern District of California. Certain
executive officers and directors of Diamond are also named as
defendants. The plaintiffs purport to represent a class of all persons
who purchased Diamond's Common stock between October 18, 1995 and June
20, 1996 (the "Class Period"). The complaints allege claims under the
federal securities law and California law. The plaintiffs allege that
Diamond and the other defendants made various material
misrepresentations and omissions during the Class Period. The complaints
do not specify the amount of damages sought. Diamond believes that it
has good defenses to the claims alleged in the lawsuits and will defend
itself vigorously against these actions. No trial date has been set for
any of these actions.
On August 4, 1999, a purported class action complaint was filed against
the Company and the members of its Board of Directors. The complaint
purports to be brought on behalf of all the stockholders of the
Company. The complaint arises out of the pending merger of the Company
with S3. The complaint alleges that the Company and the members of the
Board of Directors breached their fiduciary duties to the stockholders
by failing to obtain reasonable consideration for the Company's
stockholders in the S3 transaction. The complaint seeks an injunction
against the transaction, rescission of the transaction, compensatory
damages, and other remedies. The defendants have not yet responded to
the complaint. No trial date or other schedule has been established in
this matter.
On April 23, 1999, 3Dfx Interactive, Inc. ("3Dfx") filed a lawsuit
against the Company for breach of contract based upon unpaid invoices
in the amount of $3,895,225. On June 4, 1999 the Company filed an
answer and cross-complaint alleging breach of contract, breach of the
implied covenant of good faith and fair dealing, breach of implied
warranty and negligence. The Company's cross-claim seeks offsets
totaling $4,868,035 for (1) 3Dfx's breach of an agreement to provide
price advantages and other "most favored customer" terms to the Company
and (2) defective 3Dfx product. These damages totally offset the amount
claimed by 3Dfx for unpaid invoices and result in a net claim of
$941,155 by the Company. At the time it filed its complaint, 3Dfx
sought to attach Company assets worth $3,895,225. On June 16, 1999
the court issued a right to attach order in the amount of
$2,859,035. The Company thereafter substituted a bond for the
attached property, and all attached assets were released. Although
discovery has commenced, the parties are pursuing a mediation of their
dispute. The Company has amended its cross-complaint to seek an
accounting of 3Dfx's business records to facilitate the determination
of the Company's damages. No trial date has been set.
Sega initiated a claim for arbitration in Tokyo, Japan against the
Company in December 1998. The claim arises out of an agreement entered
into between Sega and the Company in September 1995, in which Sega
agreed to provide the Company with Sega game software that the Company
would bundle with its 3-D graphics board "The Edge." Sega claims that
the Company breached the parties' agreement by failing to pay Sega a
contractual minimum royalty fee for the games as set forth in the
agreement. Sega claims as damages unpaid royalties and pre-judgment
interest of approximately twelve million dollars ($12,000,000). On
May 28, 1999, the Company responded to Sega's claims by filing an
answer in which it denied the material allegations of Sega's claims.
The Company will file a supplemental brief on these issues with the
arbitration panel on or before August 23, 1999. A hearing on the
merits of this action is currently scheduled for September 2, 1999.
The Company contests the material allegations of Sega's claims. In
addition, the Company has pleaded that Sega's failure to provide it
with 3-D optimized game software on a timely basis adversely affected
sales of The Edge. The Company claims that these lost sales and
profits therefrom should provide an offset to Sega's claims in the
arbitration.
Diamond 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 Diamond. In the opinion of management,
the ultimate disposition of these proceedings will not have a materially
adverse effect on Diamond's consolidated financial position or future
results of operations.
The ultimate outcome of the actions described above cannot presently be
determined. Accordingly, no provision for any liability or loss that
may result from adjudication or settlement thereof has been made in the
accompanying financial statements.
On August 2, 1999, the Company and the Recording Industry Association
of America, Inc. (the "RIAA") entered into a settlement, pursuant to
which the lawsuit filed by the RIAA against the Company is to be
dismissed. The Company and the RIAA have announced the mutually
satisfactory resolution of outstanding legal issues. The terms of the
settlement are confidential.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES OF MARKET RISK
Reference is made to Part II, Item 7A, Quantitative and Qualitative
Disclosures About Market Risk, in the Registrant's Annual Report on Form
10-K for the year ended December 31, 1998. The nature and scope of
market risks addressed therein have not materially changed.
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Diamond has been named as a defendant in several putative class action
lawsuits which were filed in June and July of 1996 and in June 1997 in
the California Superior Court for Santa Clara County and the U.S.
District Court for the Northern District of California. Certain
executive officers and directors of Diamond are also named as
defendants. The plaintiffs purport to represent a class of all persons
who purchased Diamond's Common stock between October 18, 1995 and June
20, 1996 (the "Class Period"). The complaints allege claims under the
federal securities law and California law. The plaintiffs allege that
Diamond and the other defendants made various material
misrepresentations and omissions during the Class Period. The complaints
do not specify the amount of damages sought. Diamond believes that it
has good defenses to the claims alleged in the lawsuits and will defend
itself vigorously against these actions. No trial date has been set for
any of these actions.
On August 4, 1999, a purported class action complaint was filed against
the Company and the members of its Board of Directors. The complaint
purports to be brought on behalf of all the stockholders of the
Company. The complaint arises out of the pending merger of the Company
with S3. The complaint alleges that the Company and the members of the
Board of Directors breached their fiduciary duties to the stockholders
by failing to obtain reasonable consideration for the Company's
stockholders in the S3 transaction. The complaint seeks an injunction
against the transaction, rescission of the transaction, compensatory
damages, and other remedies. The defendants have not yet responded to
the complaint. No trial date or other schedule has been established in
this matter.
On April 23, 1999, 3Dfx Interactive, Inc. ("3Dfx") filed a lawsuit
against the Company for breach of contract based upon unpaid invoices
in the amount of $3,895,225. On June 4, 1999 the Company filed an
answer and cross-complaint alleging breach of contract, breach of the
implied covenant of good faith and fair dealing, breach of implied
warranty and negligence. The Company's cross-claim seeks offsets
totaling $4,868,035 for (1) 3Dfx's breach of an agreement to provide
price advantages and other "most favored customer" terms to the Company
and (2) defective 3Dfx product. These damages totally offset the amount
claimed by 3Dfx for unpaid invoices and result in a net claim of
$941,155 by the Company. At the time it filed its complaint, 3Dfx
sought to attach Company assets worth $3,895,225. On June 16, 1999
the court issued a right to attach order in the amount of
$2,859,035. The Company thereafter substituted a bond for the
attached property, and all attached assets were released. Although
discovery has commenced, the parties are pursuing a mediation of their
dispute. The Company has amended its cross-complaint to seek an
accounting of 3Dfx's business records to facilitate the determination
of the Company's damages. No trial date has been set.
Sega initiated a claim for arbitration in Tokyo, Japan against the
Company in December 1998. The claim arises out of an agreement entered
into between Sega and the Company in September 1995, in which Sega
agreed to provide the Company with Sega game software that the Company
would bundle with its 3-D graphics board "The Edge." Sega claims that
the Company breached the parties' agreement by failing to pay Sega a
contractual minimum royalty fee for the games as set forth in the
agreement. Sega claims as damages unpaid royalties and pre-judgment
interest of approximately twelve million dollars ($12,000,000). On
May 28, 1999, the Company responded to Sega's claims by filing an
answer in which it denied the material allegations of Sega's claims.
The Company will file a supplemental brief on these issues with the
arbitration panel on or before August 23, 1999. A hearing on the
merits of this action is currently scheduled for September 2, 1999.
The Company contests the material allegations of Sega's claims. In
addition, the Company has pleaded that Sega's failure to provide it
with 3-D optimized game software on a timely basis adversely affected
sales of The Edge. The Company claims that these lost sales and
profits therefrom should provide an offset to Sega's claims in the
arbitration.
Diamond 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 Diamond. In the opinion of management,
the ultimate disposition of such proceedings will not have a materially
adverse effect on Diamond's consolidated financial position or future
results of operations.
The ultimate outcome of the actions described above cannot presently be
determined. Accordingly, no provision for any liability or loss that
may result from adjudication or settlement thereof has been made in the
accompanying financial statements.
On August 2, 1999, the Company and the Recording Industry Association
of America, Inc. (the "RIAA") entered into a settlement, pursuant to
which the lawsuit filed by the RIAA against the Company is to be
dismissed. The Company and the RIAA have announced the mutually
satisfactory resolution of outstanding legal issues. The terms of the
settlement are confidential.
ITEM 2. CHANGES IN SECURITIES
Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The following matters were approved at Diamond's Annual Meeting of
Stockholders held on May 21, 1999.
a) The following Directors were elected:
Directors Votes For Withheld
William Schroeder 25,598,927 3,396,548
Bruce C. Edwards 25,877,522 3,117,953
Carl W. Nuen 25,857,942 3,137,533
Gregorio Reyes 25,857,828 3,137,647
Jeffrey D. Saper 25,892,812 3,102,663
James T. Schraith 25,880,044 3,115,431
b) The shareholders approved the following proposals:
Number of Common Shares Voted
For Against Abstain Non-Vote
---------- ---------- ---------- ----------
To approve an amendment to
the 1995 Employee Stock
Purchase Plan 26,975,579 1,935,370 4,526 6,291,177
To approve an amendment to
the 1995 Director Option
Plan 25,958,406 2,955,311 81,758 6,291,177
To ratify the appointment of
PricewaterhouseCoopers LLP
as independent accountants 28,347,290 523,535 124,650 6,291,177
ITEM 5. OTHER INFORMATION
Pursuant to Rule 14a-4(c)(1) under the Securities and Exchange Act of
1934, the proxies of management would be allowed to use their
discretionary voting authority with respect to any non-Rule 14a-8
stockholder proposal raised at Diamond's annual meeting of stockholders,
without any discussion of the matter in the proxy statement, unless the
stockholder has notified Diamond of such proposal at least 45 days prior
to the month and day on which Diamond mailed its prior year's proxy
statement. Since Diamond mailed its proxy statement for the 1999 annual
meeting of stockholders on April 26, 1999, the deadline for receipt of
any such stockholder proposal for the 2000 annual meeting of
stockholders is March 12, 2000.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibits
10.1 Change of Control Severance Agreement with William J.
Schroeder dated June 21, 1999.
27.1 Financial Data Schedule (refer to EDGAR Filing)
Reports on Form 8-K
Merger Agreement and Credit Agreement between Diamond and S3 as
filed on Form 8-K on June 25, 1999 and as amended on Form 8-K/A
on July 13, 1999.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
DIAMOND MULTIMEDIA SYSTEMS, INC.
Date: August 13, 1999 /s/ William J. Schroeder
William J. Schroeder
President and Chief Executive Officer
Date: August 13, 1999 /s/ James M. Walker
James M. Walker
Senior Vice President and Chief Financial Officer