| ESS TECHNOLOGY INC Item 1A Risk Factors We operate in highly competitive markets |
| The markets in which we compete are intensely competitive and are characterized by rapid technological changes, price reductions and short product life cycles |
| Competition typically occurs at the design stage, when customers evaluate alternative design approaches requiring integrated circuits |
| Because of short product life cycles, there are frequent design win competitions for next-generation systems |
| We expect competition to increase in the future from existing competitors and from other companies that may enter our existing or future markets with products that may be provided at lower costs or provide higher levels of integration, higher performance or additional features |
| In some cases, our competitors have been acquired by even larger organizations, giving them access to even greater resources with which to compete with us |
| Advancements in technology can change the competitive environment in ways that may be adverse to us |
| Unless we are able to develop and deliver highly desirable products in a timely manner continuously and achieve market domination in one or more product lines, we will not be able to achieve long-term sustainable success, in this fast consolidating industry |
| If we are only able to offer commodity products, our results of operations and long-term success will suffer and we will fall prey to stronger competitors |
| For example, today’s high-performance central processing units in PCs have enough excess computing capacity to perform many of the functions that formerly required a separate chip set, which has reduced demand for our PC audio chips, among other chips |
| The announcements and commercial shipments of competitive products could adversely affect sales of our products and may result in increased price competition that would adversely affect the average selling price (“ASP”) and margins of our products |
| The following factors may affect our ability to compete in our highly competitive markets: • The timing and success of our new product introductions and those of our customers and competitors; • The timely shipment of new products of our Video business, including the new Phoenix line of DVD products, an integrated servo DVD product and an integrated RF DVD product; • The timely shipment of new products of our Digital Imaging business, including our new 4T SOC 1dtta3 Megapixel sensor chip, our new 4T SOC 2dtta0 Megapixel sensor chip, and our new VGA SOC sensor chip; • The ability to obtain adequate foundry capacity and sources of raw materials; • The price, quality and performance of our products and the products of our competitors; • The emergence of new multimedia standards; • The development of technical innovations; • The rate at which our customers integrate our products into their products; • The number and nature of our competitors in a given market; and • The protection of our intellectual property rights |
| Our business is highly dependent on the expansion of the consumer electronics market |
| Our primary focus has been developing products primarily for the consumer electronics market |
| Currently, our sales of video system processor chips to the DVD and VCD player markets in the Video business and Digital imaging products in the Digital Imaging business account for a majority of our revenues |
| We expect these products will continue to account for a significant portion of our net revenues for the foreseeable future |
| Given the current economic environment, consumer spending on DVD players and cellular camera phones may not increase as expected or may even weaken or fall |
| In addition, due to declines in the VCD market demand caused by cannibalization by low-price DVD products, we have entered into a certain license arrangement for our VCD products |
| See Part II, Item 8, Note 12, “Business Segment Information and Concentration of Certain Risks — Significant Customer and Distributors |
| ” Consequently, we continue to 14 _________________________________________________________________ [65]Table of Contents invest in new product lines for the consumer electronics market in both our business segments |
| Nonetheless, our strategy in these new markets may not be successful |
| If the markets for these products and applications decline or fail to develop as expected, or if we are not successful in our efforts to market and sell our products to manufacturers who incorporate our chip into their products, it could have a material adverse effect on our business financial conditions and results of operations |
| Our quarterly operating results are subject to fluctuations that may cause volatility or a decline in the price of our stock |
| Historically, our quarterly operating results have fluctuated significantly |
| Our future quarterly operating results will likely fluctuate from time to time and may not meet the expectations of securities analysts and investors in a particular future period |
| The price of our common stock could decline due to such fluctuations |
| The following factors may cause significant fluctuations in our future quarterly operating results: • Charges related to the net realizable value of inventories and/or excess inventories; • Changes in demand or sales forecast for our products; • Changes in the mix of products sold and our revenue mix; • The timely implementation of customer-specific hardware and software requirements for specific design wins; • Increasing pricing pressures and resulting reduction in the ASP of any or all of our products; • Availability and cost of foundry capacity; • Gain or loss of significant customers; • Seasonal customer demand; • The cyclical nature of the semiconductor industry; • The timing of our and our competitors’ new product announcements and introductions and the market acceptance of new or enhanced versions of our and our customers’ products; • The timing of significant customer orders; • Charges related to the impairment of other intangible assets; • Loss of key employees which could impact sales or the pace of product development; • The “turns” basis of most of our orders, which makes backlog a poor indicator of the next quarter’s revenue; • The potential for large adjustments due to resolution of multi-year tax examinations; • The lead time we normally receive for our orders, which makes it difficult to predict sales until the end of the quarter; • Availability and cost of raw materials; • Significant increases in expenses associated with the expansion of operations; and • A shift in manufacturing of consumer electronic products away from Asia |
| We often purchase inventories based on sales forecasts and if anticipated sales do not materialize, we may continue to experience significant inventory charges |
| We currently place non-cancelable orders to purchase our products from independent foundries and other vendors on an approximately three-month rolling basis, while our customers generally place purchase orders (frequently with short lead times) with us that may be cancelled without significant penalty |
| Some of these customers may require us to demonstrate our ability to deliver in response to their short lead-time |
| In order to 15 _________________________________________________________________ [66]Table of Contents accommodate such customers, we have to commit to certain inventories before we have a firm commitment from our customers |
| If anticipated sales and shipments in any quarter are cancelled, do not occur as quickly as expected or subject to declining ASP, expense and inventory levels could be disproportionately high and we may be required to record significant inventory charges in our statement of operations in a particular period |
| In accordance with our accounting policy, we reduce the carrying value of our inventories for estimated slow-moving, excess, obsolete, damaged or otherwise unmarketable products by an amount that is the difference between cost and estimated market value based on forecasts of future demand and market conditions |
| As our business grows, we may increasingly rely on distributors, which may further impede our ability to accurately forecast product orders |
| Additionally, we may venture into new products with different supply chain and logistics requirements which may in turn cause excess or shortage of inventory |
| We may need to acquire other companies or technologies to successfully compete in our industry and we may not be successful acquiring key targets or integrating our acquisitions into our business |
| We believe the semiconductor industry is experiencing a general industry consolidation |
| To achieve long-term success, a semiconductor company must be able to offer high-demand products and renew its offerings in a timely manner |
| In order to meet such a high turn over in product offering, in addition to our own research and development of new products, we continue to regularly consider the acquisition of other companies or the products and technologies of other companies to complement our existing product offerings, improve our market coverage and enhance our technological capabilities |
| There may be technologies that we need to acquire or license in order to remain competitive |
| However, we may not be able to identify and consummate suitable acquisitions and investments or be able to acquire them at costs that are competitive |
| Acquisitions and investments carry risks that could have a material adverse effect on our business, financial condition and results of operations, including: • The failure of the acquired products or technology to attain market acceptance, which may result from our inability to leverage such products and technology successfully; • The failure to integrate acquired products and business with existing products and corporate culture; • The inability to retain key employees from the acquired company; • Diversion of management attention from other business concerns; • The potential for large write-offs of intangible assets; • Issuances of equity securities dilutive to our existing shareholders; • The incurrence of substantial debt and assumption of unknown liabilities; and • Our ability to properly access and maintain an effective internal control environment over an acquired company in order to comply with public reporting requirements |
| Our research and development investments may fail to enhance our competitive position |
| We invest a significant amount of time and resources in our research and development activities to maintain and enhance our competitive position |
| Technical innovations are inherently complex and require long development cycles and the commitment of extensive engineering resources |
| We incur substantial research and development costs to confirm the technical feasibility and commercial viability of a product that in the end may not be successful |
| If we are not able to successfully complete our research and development projects on a timely basis, we may face competitive disadvantages |
| There is no assurance that we will recover the development costs associated with these projects or that we will be able to secure the financial resources necessary to fund future research and development efforts |
| Some of our significant projects include the development of a next generation technology |
| For the Video business, this includes the next generation of DVD chip that will incorporate BluRay and HD-DVD technology |
| This family of products will require a new architecture and a complete SOC design, which is extremely complex and may not ultimately be feasible |
| For the Digital Imaging business, this includes the 16 _________________________________________________________________ [67]Table of Contents development of four transistor (4T) and shared four transistor (S4T) technology and the integration of the image sensor with the image processor on a single, integrated chip (SOC or UniMegaxel or UniVGA products) |
| If we are unable to successfully develop these next generation chips, or complete other significant research and development projects, our business, financial condition and results of operations could be materially adversely affected |
| Our sales may fluctuate due to seasonality and changes in customer demand |
| Since we are primarily focused on the consumer electronics market, we are likely to be affected both by changes in consumer demand and by seasonality in the sales of our products |
| Historically, over half of consumer electronic products are sold during the holiday seasons |
| Consequently, our results during a period that covers a non-holiday season may vary dramatically from a period that covers a holiday season |
| Consumer electronic product sales have historically been much higher during the holiday shopping seasons than during other times of the year, although the manufacturers’ shipments vary from quarter to quarter depending on a number of factors, including retail levels and retail promotional activities |
| In addition, consumer demand often varies from one product to another in consecutive holiday seasons and is strongly influenced by the overall state of the economy |
| Because the consumer electronic market experiences substantial seasonal fluctuations, seasonal trends may cause our quarterly operating results to fluctuate significantly and our inability to forecast these trends may adversely affect the market price of our common stock |
| For instance, as ASPs for DVD products decline, customer demands for VCD products may shift to DVD products and ultimately render our VCD products, from which we enjoy a healthy product margin, even under our recent arrangement to license our VCD products, obsolete |
| In the future, if the market for our products is not as strong during the holiday seasons, whether as a result of changes in consumer tastes, changes in our mix of products, or because of an overall reduction in consumer demand due to economic conditions, we may fail to meet expectations of securities analysts and investors which could cause our stock price to fall |
| Our success within the semiconductor industry depends upon our ability to develop new products in response to rapid technological changes and evolving industry standards |
| The semiconductor industry is characterized by rapid technological changes, evolving industry standards and product obsolescence |
| Our success is highly dependent upon the successful development and timely introduction of new products at competitive prices and performance levels |
| Recently our financial performance has suffered because we were late with product introductions compared to our competition and we expect this trend in our financial performance to continue until we deliver new product offerings that are competitive and accepted by the market |
| The success of new products depends on a number of factors, including: • Anticipation of market trends; • Timely completion of design, development, and testing of both the hardware and software for each product; • Timely completion of customer specific design, development and testing of both hardware and software for each design win; • Market acceptance of our products and the products of our customers; • Offering new products at competitive prices; • Meeting performance, quality and functionality requirements of customers and OEMs; and • Meeting the timing, volume and price requirements of customers and OEMs |
| Our products are designed to conform to current specific industry standards, however, we have no control over future modifications to these standards |
| Manufacturers may not continue to follow the current standards, which would make our products less desirable to manufacturers and reduce our sales |
| Our success is highly dependent upon our ability to develop new products in response to these changing industry standards |
| 17 _________________________________________________________________ [68]Table of Contents Our products are subject to increasing pricing pressures |
| The markets for most of the applications for our chips are characterized by intense price competition |
| The willingness of OEMs to design our chips into their products depends, to a significant extent, upon our ability to sell our products at cost-effective prices |
| We expect the ASP of our existing products (particularly our DVD decoder and digital imaging chip products) to decline significantly over their product lives as the markets for our products mature, new products or technology emerge and competition increases |
| If we are unable to reduce our costs sufficiently to offset declines in product prices or are unable to introduce more advanced products with higher margins, our gross margins may decline in the future |
| We may lose business to competitors who have significant competitive advantages |
| Our existing and potential competitors consist, in part, of large domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources, greater intellectual property rights, broader product lines and longer-standing relationships with customers than we have |
| These competitors may have more visibility into market trends, which is critically important in an industry characterized by rapid technological changes, evolving industry standards and product obsolescence |
| Our competitors also include a number of independent and emerging companies who may be able to better adapt to changing market conditions and customer demand |
| In addition, some of our current and potential competitors maintain their own semiconductor fabrication facilities and could benefit from certain capacity, cost and technical advantages |
| We expect that market experience to date and the predicted growth of the market will continue to attract and motivate more and stronger competitors |
| In the Video business, DVD and VCD players face significant competition from video-on-demand, VCRs and other video formats |
| Further, VCDs are being replaced by cheaper DVDs |
| We expect that the DVD platform will face competitors from other platforms including set-top-boxes, as well as multi-function game boxes being manufactured and sold by large companies |
| Some of our competitors may be more diversified than us and supply chips for multiple platforms |
| In the Digital Imaging business, our digital imaging products face significant competition who may have greater relationships with lens module assemblers and other suppliers that may assist them in attaining design wins with cellular phone manufacturers |
| Declines in DVD and VCD sales have negatively impacted our results of operation in 2005 |
| Further decreases in DVD, VCD and digital imaging sales will have a disproportionate effect on us as they are currently our most important product lines |
| Any of these competitive factors could reduce our sales and market share and may force us to lower our prices, adversely affecting our business, financial condition and results of operations |
| Our business is dependent upon retaining key personnel and attracting new employees |
| Our success depends to a significant degree upon the continued contributions of our top management Fred SL Chan, our Chairman of the Board, and Robert L Blair, our President and CEO In the past, Mr |
| Chan has served as our President and Chief Executive Officer in addition to being our Chairman of the Board |
| Chan is critical to maintaining many of our key relationships with customers, suppliers and foundries in Asia |
| Blair, or any of our other key executives including our CFO could adversely affect our business |
| We may not be able to retain our other key personnel and searching for key personnel replacements could divert the attention of other senior management and increase our operating expenses |
| Additionally, to manage our future operations effectively, we will need to hire and retain additional management personnel, design personnel as well as hardware and software engineers |
| We may have difficulty recruiting these employees or integrating them into our business |
| The loss of services of any of our key personnel, the inability to attract and retain qualified personnel in the future, or delays in hiring required personnel, particularly design personnel and software engineers, could make it difficult to implement our key business strategies, such as timely and effective product introductions |
| 18 _________________________________________________________________ [69]Table of Contents We rely on a single distributor for a significant portion of our revenues and if this relationship deteriorates our financial results could be adversely affected |
| Sales through our largest distributor FE Global (a Singapore-based company) were approximately 37prca, 51prca and 63prca of our net revenues for the fiscal years ended December 31, 2005, 2004 and 2003, respectively |
| FE Global is not subject to any minimum purchase requirements and can discontinue marketing any of our products at any time |
| In addition, FE Global has rights of return for unsold products and rights to pricing allowances to compensate for rapid, unexpected price changes |
| Therefore, we do not recognize revenue until FE Global sells through to our end-customers |
| If our relationship with FE Global deteriorates, our quarterly results could fluctuate significantly as we experience short-term disruption to our sales and collection processes, particularly in light of the fact that we maintain significant accounts receivable from FE Global |
| As our business grows, we may increasingly rely on distributors, which may reduce our exposure to future sales opportunities |
| Although we believe that we could replace FE Global as our distributor for the Hong Kong and China markets, there can be no assurance that we could replace FE Global in a timely manner or if a replacement were found that the new distributor would be as effective as FE Global in generating revenue for us |
| Our customer base is highly concentrated, so the loss of a major customer could adversely affect our business |
| A substantial portion of our net revenues has been derived from sales to a small number of our customers |
| During the fiscal year ended December 31, 2005, sales to our top five end-customers across business segments (including end-customers that buy our products from our largest distributor FE Global) accounted for approximately 53prca of our net revenues |
| In 2005 we entered into an exclusive license agreement with a third party, pursuant to which our VCD products are distributed in China and India |
| This risk is also acute in our Digital Imaging business, which currently has few customers and low sales volume |
| We expect this concentration of sales to continue along with other changes in the composition of our customer base |
| The reduction, delay or cancellation of orders from one or more major customers or the loss of one or more major customers could materially and adversely affect our business, financial condition and results of operations |
| In addition, any difficulty in collecting amounts due from one or more key customers could harm our financial condition |
| We may continue to expand into new businesses and product lines in which there may be a concentrated customer base and for which we may be required to purchase custom inventories to meet our customers’ needs |
| As demonstrated by our entry into the Digital Imaging business through our acquisition of Pictos, Inc, we have in the past and will continue to regularly consider the expansion into new businesses and product lines by acquisition or otherwise |
| As a result of our prior expansions into new businesses and new product lines, we may continue to sell our products to a highly concentrated customer base |
| The reduction, delay or cancellation of orders from one or more major customers or the loss of one or more major customers in these new businesses or product lines could render our venture in a new product line, such as digital imaging, unsuccessful, and resulting in a material adverse effect on our business, financial condition and results of operations |
| As a result of our acquisitions such as Pictos, we currently purchase custom inventories for certain of our product lines such as image sensor modules for camera enabled cellular phones |
| This custom inventory is highly tailored to each customer’s specifications |
| We may also be forced to write off such custom inventory, which may result in a material adverse effect on our business, financial condition and results of operations |
| 19 _________________________________________________________________ [70]Table of Contents Because we are dependent upon a limited number of suppliers, we could experience delivery disruptions or unexpected product cost increases |
| We depend on a limited number of suppliers to obtain adequate supplies of quality raw materials on a timely basis |
| We do not generally have guaranteed supply arrangements with our suppliers |
| If we have difficulty in obtaining materials in the future, alternative suppliers may not be available, or if available, these suppliers may not provide materials in a timely manner or on favorable terms |
| If we cannot obtain adequate materials for the manufacture of our products, we may be forced to pay higher prices, experience delays and our relationships with our customers may suffer |
| In addition, we license certain technology from third parties that is incorporated into many of our key products |
| If we are unable to obtain or license the technology on commercially reasonable terms and on a timely basis, we will not be able to deliver products to our customers on competitive terms and in a timely manner and our relationships with our customers may suffer |
| We may not be able to adequately protect our intellectual property rights from unauthorized use and we may be subject to claims of infringement of third-party intellectual property rights |
| To protect our intellectual property rights we rely on a combination of patents, trademarks, copyrights and trade secret laws and confidentiality procedures |
| We have numerous patents granted in the United States with some corresponding foreign patents |
| These patents will expire at various times |
| We cannot assure you that patents will be issued from any of our pending applications or applications in preparation or that any claims allowed from pending applications or applications in preparation will be of sufficient scope or strength |
| We may not be able to obtain patent protection in all countries where our products may be sold |
| Also, our competitors may be able to design around our patents |
| The laws of some foreign countries may not protect our products or intellectual property rights to the same extent, as do the laws of the United States |
| We cannot assure you that the actions we have taken to protect our intellectual property will adequately prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology |
| The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions |
| Litigation by or against us could result in significant expense and divert the efforts of our technical and management personnel, whether or not such litigation results in a favorable determination for us |
| Any claim, even if without merit, may require us to spend significant resources to develop non-infringing technology or enter into royalty or cross-licensing arrangements, which may not be available to us on acceptable terms, or at all |
| We may be required to pay substantial damages or cease the use and sale of infringing products, or both |
| In general, a successful claim of infringement against us in connection with the use of our technologies could adversely affect our business and our results of operations could be significantly harmed |