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 March 31, 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
March 31, 1999 was 35,286,652.
 
 
 
<PAGE>
 
DIAMOND MULTIMEDIA SYSTEMS, INC.
 
INDEX TO FORM 10-Q
 
 
 
 
PART I - FINANCIAL INFORMATION:
 
 
ITEM 1- Financial Statements
 
Consolidated Balance Sheets as of March 31, 1999
and December 31, 1998
 
Consolidated Statements of Operations for the three months
ended March 31, 1999 and 1998
 
Consolidated Statements of Cash Flows for the three months
ended March 31, 1999 and 1998
 
Notes to Consolidated Financial Statements
 
ITEM 2 - Management's Discussion and Analysis of
          Financial Condition and Results of Operations
 
 
PART II - OTHER INFORMATION
 
ITEM 1 - Legal proceedings
 
ITEM 2 - Changes in securities
 
ITEM 3 - Defaults Upon Senior Securities
 
ITEM 4 - Submission of Matters to a Vote of Security Holders
 
ITEM 5 - Other Information
 
ITEM 6 - Exhibits and Reports on Form 8-K
 
SIGNATURES
 
 
<PAGE>
 
PART I - FINANCIAL INFORMATION
 
ITEM 1 - Financial Statements
 
                DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
               (UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
                                                    March 31,     December 31,
                                                        1999          1998
                                                    ------------  ------------
<S>                                                 <C>           <C>
                               ASSETS
Current assets:
  Cash and cash equivalents........................     $34,350       $24,621
  Restricted cash..................................       5,500         5,500
  Short-term investments...........................       4,501         5,951
  Trade accounts receivable, net of allowance
    for doubtful accounts of $587 and $2,095
    as of March 31, 1999 and December 31, 1998.          89,879        94,027
  Inventories......................................      51,546        48,892
  Prepaid expenses and other current assets........      13,216        13,041
  Income taxes receivable..........................       6,285         9,735
  Deferred income taxes............................      50,037        50,071
                                                    ------------  ------------
       Total current assets........................     255,313       251,838
  Property, plant and equipment, net...............      28,276        27,288
  Other assets.....................................       1,372         1,415
  Goodwill and other intangibles, net..............      25,246        26,369
                                                    ------------  ------------
       Total assets................................    $310,207      $306,910
                                                    ============  ============
 
                             LIABILITIES
Current liabilities:
  Current portion of long-term debt................     $59,494       $45,516
  Trade accounts payable...........................      68,814        75,727
  Accrued liabilities..............................      20,903        21,979
  Deferred income..................................       2,535         7,200
  Income taxes payable.............................       9,117         8,568
                                                    ------------  ------------
       Total current liabilities...................     160,863       158,990
Long-term debt, net of current portion.............       1,485         1,550
                                                    ------------  ------------
       Total liabilities...........................     162,349       160,540
                                                    ------------  ------------
                        STOCKHOLDERS' EQUITY
Preferred stock, par value $.001; Authorized -
   8,000 shares at March 31, 1999 and
   December 31, 1998; none issued and outstanding..        --            --
Common stock, par value $.001;
  Authorized - 75,000 at March 31, 1999 and
  December 31, 1998; Issued and outstanding -
  35,287 at March 31, 1999 and 35,244 at
  December 31, 1998................................          35            35
Additional paid-in capital.........................     313,367       313,214
Distributions in excess of net book value..........     (56,775)      (56,775)
Accumulated deficit................................    (108,769)     (110,104)
                                                    ------------  ------------
   Total stockholders' equity......................     147,859       146,370
                                                    ------------  ------------
     Total liabilities and stockholders' equity....    $310,207      $306,910
                                                    ============  ============
</TABLE>
  The accompanying notes are an integral part of these consolidated condensed
                             financial statements.
<PAGE>
 
 
 
 
 
                DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                (UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
                                  Three Months Ended
                                  March 31,
                                  ---------------------
                                  1999       1998
                                  ---------- ----------
<S>                               <C>        <C>
Net sales........................  $143,986   $186,196
Cost of sales....................   114,093    144,570
                                  ---------- ----------
      Gross profit...............    29,893     41,626
                                  ---------- ----------
 
Operating expenses:
  Research and development.......     6,542      7,092
  Selling, general and
    administrative...............    20,357     23,158
  Amortization of intangibles....     1,089        244
                                  ---------- ----------
       Total operating expenses..    27,989     30,494
                                  ---------- ----------
Income from operations...........     1,904     11,132
Interest income (expense), net...      (738)       336
Other income (expense), net......       741       (144)
                                  ---------- ----------
Income before provision for
  income taxes...................     1,907     11,324
Provision from income taxes......       572      3,397
                                  ---------- ----------
Net income.......................    $1,335     $7,927
                                  ========== ==========
 
Net income per share:
       Basic.....................     $0.04      $0.23
                                  ========== ==========
       Diluted...................     $0.04      $0.22
                                  ========== ==========
Shares used in per share
  calculations:
       Basic.....................    35,270     34,781
                                  ========== ==========
       Diluted...................    37,783     36,521
                                  ========== ==========
</TABLE>
  The accompanying notes are an integral part of these consolidated
                    condensed financial statements.
<PAGE>
 
 
 
               DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                           (UNAUDITED; IN THOUSANDS)
<TABLE>
<CAPTION>
                                                            Three Months Ended
                                                                 March 31,
                                                        ----------------------
                                                        1999        1998
                                                        ----------  ----------
<S>                                                     <C>         <C>
Cash flows from operating activities:
  Net income...........................................    $1,335      $7,927
  Adjustments to reconcile net loss to net cash
  provided by (used in) operating activities:
     Depreciation and amortization.....................     3,166       1,701
     Provision for doubtful accounts...................    (1,509)        (54)
     Provision for excess and obsolete inventories.....   (12,030)      4,920
     Deferred income taxes.............................        35         948
  Changes in assets and liabilities:
     Trade accounts receivables........................     5,657      (4,025)
     Inventories.......................................     9,376     (18,729)
     Prepaid expenses and other assets.................      (132)       (408)
     Income taxes receivable...........................     3,450      19,014
     Trade accounts payable and other liabilities......    (7,440)      3,167
     Deferred income on distributor inventories........    (4,665)         --
                                                        ----------  ----------
       Net cash provided by operating
         activities....................................    (2,757)     14,461
                                                        ----------  ----------
Cash flows from investing activities:
   Purchases of property and equipment.................    (3,031)     (4,711)
   Purchases of short-term investments.................     1,450      (2,006)
                                                        ----------  ----------
     Net cash used in investing activities.............    (1,581)     (6,717)
                                                        ----------  ----------
Cash flows from financing activities:
   Proceeds from issuance of common stock..............       153       2,394
   Proceeds from term loans and revolving credit
       facilities......................................    50,786      22,971
   Payments and maturities of term loans and
       revolving credit facilities.....................   (36,769)    (24,032)
   Repayments of capital lease financings..............      (103)       (219)
                                                        ----------  ----------
     Net cash provided by financing activities.........    14,067       1,114
                                                        ----------  ----------
Net increase in cash and cash equivalents..............     9,729       8,858
Cash and cash equivalents at beginning of period.......    24,621      85,929
                                                        ----------  ----------
Cash and cash equivalents at end of period.............   $34,350     $94,787
                                                        ==========  ==========
</TABLE>
   The accompanying notes are an integral part of these consolidated condensed
                             financial statements.
<PAGE>
 
 
 
 
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 quarter ended March 31, 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):
 
<TABLE>
<CAPTION>
                                March 31,     December 31,
                                   1999           1998
                               ------------   ------------
<S>                            <C>            <C>
Raw materials .............        $12,897        $17,388
Work in process............          8,062         20,739
Finished goods.............         30,587         10,765
                               ------------   ------------
                                   $51,546        $48,892
                               ============   ============
</TABLE>
 
 
The Company evaluates it's inventory position on  regular basis and as a
result, has determined the it has inventory in excess of short-term needs
at March 31, 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 income) and
denominator (number of shares) used in the basic and diluted EPS calculation:
(Dollar amounts, in thousands)
 
<TABLE>
<CAPTION>
                                  Three Months Ended
                                  March 31,
                                  ---------------------
                                  1999       1998
                                  ---------- ----------
<S>                               <C>        <C>
Basic:
  Net income.....................    $1,335     $7,927
  Average Common
    Shares Outstanding...........    35,270     34,781
                                  ---------- ----------
Basic EPS........................     $0.04      $0.23
                                  ========== ==========
 
Diluted:
  Net income.....................    $1,335     $7,927
  Average Common
    Shares Outstanding...........    35,270     34,781
  Stock options..................     2,529      1,740
                                  ---------- ----------
Total shares.....................    37,799     36,521
 
Diluted EPS......................     $0.04      $0.22
                                  ========== ==========
</TABLE>
 
4.      LITIGATION
 
The Company has been named as a defendant in several putative
class action lawsuits which were filed in June and July, 1996 and
June, 1997 in the California Superior Court for Santa Clara County
and the U.S. District Court for the Northern District of
California. Certain executive officers and directors of the
Company are also named as defendants. The plaintiffs purport to
represent a class of all persons who purchased the Company's
Common Stock between October 18, 1995 and June 20, 1996 (the
"Class Period"). The complaints allege claims under the federal
securities law and California law. The plaintiffs allege that the
Company and the other defendants made various material
misrepresentations and omissions during the Class Period. The
complaints do not specify the amount of damages sought. The
Company believes that it has good defenses to the claims alleged
in the lawsuits and will defend itself vigorously against these
actions. No trial date has been set for any of these actions. The
ultimate outcome of these actions cannot be presently determined.
Accordingly, no provision for any liability or loss that may
result from adjudication or settlement thereof has been made in
the accompanying consolidated financial statements.
 
The Company has been named as a defendant in a lawsuit filed on
October 9, 1998 in the United States District Court for the
Central District of California.  Plaintiffs are the Recording
Industry Association of America, Inc. (the "RIAA"), a trade
organization representing recording companies and the Alliance of
Artists and Recording Companies (the "AARC") an organization
controlled by the RIAA which exists to distribute royalties
collected by the copyright office.  The complaint alleges that the
Company's Rio product, a portable music player, is subject to
regulation under the Audio Home Recording Act (the "AHRA") and
that the device does not comply with the requirements of the AHRA.
On October 16, 1998 a hearing was held and the Court issued a
Temporary Restraining Order preventing the Company from
manufacturing or distributing the Rio product for a period of ten
days.  On October 26, 1998 a hearing was held to determine if a
Preliminary Injunction should be issued to further restrain the
Company until the conclusion of the suit.  The court denied the
motion and refused to restrain the Company from manufacturing and
distributing the Rio product. The RIAA has appealed the Court's
ruling to the United States Court of Appeals for the Ninth
Circuit. Briefing has been conducted and on April 15, 1999 oral
argument was heard regarding the appeal. On November 30, 1998 the
Company filed an answer to the complaint together with
counterclaims alleging various antitrust, unfair competition and
other claims for damages as well as counterclaims seeking a
declaration the AHRA is unconstitutional. On April 26, 1999 a
hearing on a motion to dismiss certain counterclaims was held. The
Court granted the motion with respect to product defamation, trade
libel and interference with prospective economic advantage. The
Court is allowing the Company to replead these claims. No firm
trial schedule has been established. No provision for any
liability or loss that may result from adjudication or settlement
of this action has been made in the accompanying consolidated
financial statements.
 
The Company is also party to other claims and pending legal
proceedings that generally involve employment and trademark
issues.  These cases are, in the opinion of management, ordinary
and routine matters incidental to the normal business conducted by
the Company.  In the opinion of management, the ultimate
disposition of such proceedings will not have a materially adverse
effect on the Company's consolidated financial position or future
results of operations.
 
5.      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 periods ended March 31, 1998 and 1999, there are no
material differences between comprehensive income and net income.
 
 
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.
 
 
Net Sales
 
Net sales for the first quarter of 1999 decreased $42.2 million
(23%) to $144.0 million compared to $186.2 million for the first
quarter 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.
 
As a percentage of total net sales, international net sales
represented 53% of net sales in the first quarter of 1999 compared
to 46% of net sales in the first quarter of 1998. Sales declined
6% in Europe, 19% in other international markets (Asia and Latin
America), and 34% in North America in the first quarter of 1999
compared to the first quarter of 1998. European sales were 42% of
total net sales in the first quarter of 1999 compared to 34% in
the first quarter of 1998. Other international sales were 11% of
total net sales in the first quarter of 1999 compared to 10% for
the first quarter of 1998.
 
Revenues from graphics accelerators declined in part due to
reduced demand for entertainment specific products. In particular,
demand for high performance 3D-only products declined, and such
products are no longer being manufactured. In addition, while
revenues from general purpose, high-performance graphics products
did not change significantly from the first quarter of 1998 to the
first quarter of 1999, revenues for low-end graphics accelerators
declined 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 three
months of customer demand.  These Channel Inventory Levels tend
toward the low end of the months-of-supply range when demand is
stronger, sales are higher and products are in short supply.
Conversely, when demand is slower, sales are lower and products
are abundant, then Channel Inventory Levels tend toward the high
end of the months-of-supply range. 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. As planned, the Company
has taken steps to bring its Channel Inventory Levels down to a
more desirable level. This affected revenue in the third and
fourth quarters of 1998 and to a lesser extent in the first
quarter of 1999 due to lower shipment levels and price protection
charges associated with aggressive pricing. While the Company
believes that its Channel Inventory Levels for many of its
products are appropriate at this time, there are certain products
which currently have a Channel Inventory Level that is higher than
desirable. The Company 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 second
quarter of 1999.
 
Gross Margin
 
Gross profit for the first quarter of 1999 decreased $11.7
million to $29.9 million (20.8% of net sales) compared to $41.6
million (22.4% of net sales) in the first quarter of 1998. The
decrease in gross margin (gross profit as a percent of net sales)
in the first quarter of 1999 compared to the first quarter of 1998
was primarily caused by highly competitive pricing pressures in
the market for mainstream and entertainment graphics accelerators.
This was partially offset by improving margins on modem products
and margins for new products that were higher than the Company
average.
 
Research and Development
 
Research and development (R&D) expenses decreased $0.5 million
(8.0%) to $6.5 million for the first quarter of 1999, compared to
the first quarter of 1998. As a percentage of sales, R&D expenses
were 4.5% and 3.8% in the first quarter of 1999 and 1998,
respectively. This decrease in dollars spent was primarily due to
expense reduction steps the Company has taken over the past few
months, including a reduction in the number of graphics
architectures the Company develops into finished products. This
was partially offset by increased development costs for new
product lines, especially the Rio line of portable Internet music
players and the HomeFree line of networking products. The increase
as a percentage of sales reflected lower overall net sales.
 
Selling, General and Administrative
 
Selling, general and administrative (SG&A) expenses decreased
$2.8 million (12.0%) to $20.4 million for the first quarter of
1999, compared to the first quarter of 1998. As a percentage of
net sales, SG&A expenses were 14.1% and 12.4% in the first
quarters of 1999 and 1998, respectively. The decreases in SG&A in
absolute dollars for the first quarter of 1999, when compared to
the first quarter of 1998, were primarily attributable to expense
reduction measures the Company has taken over the past few months.
In addition to reductions in infrastructure costs, the Company has
spent less money promoting lower margin graphics products. This
was partially offset by incremental selling and marketing costs
associated with new product lines.
 
Amortization of Intangible Assets
 
The Company incurred amortization expense of $1.1 million in
the first quarter of 1999 compared to $0.2 million in the first
quarter of 1998.  The increase in amortization expense is due to
the amortization of the Company's purchase of Micronics in June
1998 and DigitalCast in September 1998.
 
Interest Income and Expense and Other Expense
 
Interest expense was $1.1 million in the first quarter of 1999
compared to $0.5 million in the first quarter of 1998. Interest
income was $0.4 million in the first quarter of 1999 compared to
$0.8 million in the first quarter of 1998. These changes were
caused by lower cash balances available for investment and greater
use of the Company's available lines of credit.
 
Other Income and Expense
 
Net other income was $0.7 million in the first quarter of 1999
compared to net other expense of $0.1 during the first quarter of
1998. The income in the first 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 quarter
of 1999 and the first 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 increased by $9.7 million during the
first quarter of 1999. Operating activities used $2.8 million in
cash. The primary sources of cash were decreases in inventories,
trade accounts receivable and income taxes receivable. Significant
uses of cash include reductions to trade accounts payable and
other liabilities, reduction in deferred income on distributor
inventories, and reductions to the provisions for excess and
obsolete inventory and doubtful accounts.
 
        The Company used $1.6 million in cash from investing
activities. The primary investment was the purchase of  $3.0
million in fixed assets, primarily due 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  $1.5 million.
 
        Net cash provided by financing activities was $14.1 million.
Primary sources of cash included $50.8 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 $36.8 million.
 
        At March 31, 1999, the Company had $34.4 million of cash and
cash equivalents and $4.5 million of short-term investments. Further,
as of such date, the Company had short-term lines of credit and bank
credit facilities totaling $58.5 million, of which approximately
$0.9 million was unused and available. At March 31, 1999, the
Company was in default with its loan covenants regarding liquidity.
The Company is seeking to obtain waivers for this violation.
 
        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, such systems,
applications or control devices could fail or create erroneous
results unless corrected so that they can process data related to
the year 2000.  The Company relies on its systems, applications
and devices in operating and monitoring all major aspects of its
business, including financial systems (such as general ledger,
accounts payable and payroll modules), customer services,
infrastructure, embedded computer chips, networks and
telecommunications equipment and end products.  The Company also
relies, directly and indirectly, on external systems of business
enterprises such as customers, suppliers, creditors, financial
organizations, and of governmental entities, both domestic and
international, for accurate exchange of data and movement of both
components and products. The Company recently completed the first
phase of a project to upgrade the computer hardware and software
it uses to operate, monitor and manage its business on a day to
day basis. At the end of the third quarter, the Company's
operations were converted to this system on an integrated,
worldwide basis. This effort was undertaken to significantly
improve the tools and information available to manage the Company.
These tools have the added benefit of managing data with dates
beyond December 31, 1999 as indicated by the vendors. The Company
continues to test such capabilities as part of its post-
implementation process. This testing is on schedule to be
completed during the second quarter of 1999. The Company's current
estimate is that the costs specifically associated with this
testing and validation process will not have a material adverse
effect on the result of operations or financial position of the
Company in any given year. Despite the Company's efforts to
address the year 2000 impact on its internal systems, it is
impossible to know with certainty the impact the year 2000 issue
will have on the business and what additional expenses may be
incurred. See "Certain Factors That May Affect Future Performance
- Information Technology and Telecommunications Systems."
 
In addition, even if the internal systems of the Company are
not materially affected by the year 2000 issue, the Company could
be affected through disruption in the operation of the enterprises
with which the Company interacts.  The Company is in the process
of identifying significant external agents such as service
providers, vendors, suppliers and customers and attempting to
reasonably determine their ability to manage year 2000 issues.
All automated or electronic linkages between such external agents
and the Company's internal systems are being tested as part of the
internal systems test efforts.
 
The total costs associated with year 2000 compliance are not
expected to be material to the company's financial position. The
most significant cost was averted by the Company's otherwise
planned ERP installation. Ongoing compliance efforts including IT
systems testing and the review of external agents will be carried
out in the normal course of business. The Company has not attempted
to isolate and specifically identify total expenses associated with
this effort. It is not possible for the Copmany to determine
with certainty the impact of the year 2000 problem due to
internal computer systems or external agents. The failure to
correct a material year 2000 problem or to anticipate and
mitigate a problem with an external agent could result in an
interruption in or failure of normal business activities or
operations. Such failures could materially and adversely affect
the company's results of operations, liquidity and financial
condition. Contingency plans will be developed if it appears the
Company or its key external agents will not be year 2000
compliant, and such compliance is expected to have a material
adverse impact on the Company's operations.
 
 
CERTAIN FACTORS THAT MAY AFFECT FUTURE PERFORMANCE
 
In addition to other information in this Form 10-Q, the
following are important factors that should be considered
carefully in evaluating the Company and its business.
 
Potential Fluctuations in Future Operating Results
 
The Company's operating results have fluctuated significantly in
the past on a quarterly and an annual basis and are likely to
continue to fluctuate significantly in the future depending on a
number of factors. The accompanying sections explain in greater
detail certain important factors that the Company has identified
which may affect the future performance of the Company.
 
The Company develops products in the highly competitive PC
multimedia, and communications markets, including the graphics,
video, sound, portable audio device, modem, system boards and home
networking segments. These products are very susceptible to
product obsolescence and typically exhibit a high degree of
volatility of shipment volumes over relatively short product life
cycles. The timing of introductions of new products in one
calendar quarter as opposed to an adjacent quarter can materially
affect the relative sales volumes in those quarters. In addition,
product releases by competitors and accompanying pricing actions
can materially and adversely affect the Company's revenues and
gross margins.
 
The Company sells its products to retail customers (mass
merchandisers and large chains who sell products primarily off-
the-shelf directly to end users), retail distribution customers
(distributors which resell to smaller retail chains and other
resellers), system integrators, OEM customers (customers which use
the Company's products in conjunction with other products to
produce complete computer systems for sales through both direct
and indirect distribution channels to end users), and directly to
end users via e-commerce. Reliance on indirect channels of
distribution means that the Company typically has little or no
direct visibility into end user customer demand. OEM customers
tend to provide the Company with forecasts for product
requirements, but actual order lead times remain less than 90
days. Retail and retail distribution customers typically do not
forecast product requirements and order lead times are typically
very short, as these customers tend to reorder for stock in
quantities that approximate recent sales volumes. Accordingly,
this means that future operating results are dependent on
continued sales to customers where the vast majority of the normal
volume of orders are placed with the Company within the same
calendar quarter as, and frequently within a few days of, the
customer's requested date of shipment by the Company.
 
Because the lead times of firm orders are typically short, the
Company does not have the ability to predict future operating
results with any certainty. Therefore, sudden changes that are out
of the control of the Company such as general economic conditions,
the actions or inaction of competitors, customers, third-party
vendors of operating system software and central processing unit
hardware, and independent software application vendors can have
and have had material adverse effects on the Company's
performance.
 
Other factors which may have a material adverse effect on the
Company's future performance include the management of growth and
change, rapid declines in the price of components used by the
Company, latent defects that can exist in the Company's products,
competition for the available supply of components, dependence on
subcontract manufacturers, dependence on and development of
adequate information technology systems, intellectual property
rights and dependence on key personnel.
 
Each of these factors is discussed more thoroughly in the
accompanying sections, and all of these sections should be read
carefully together to evaluate the risks associated with the
Company's Common Stock. Due to these factors, it is likely that
the operating results of the Company in some future quarter or
quarters will fall below the expectations of securities analysts
and investors. In such an event, the trading price of the
Company's Common Stock could be materially and adversely affected.
 
Revenue Volatility and Dependence on Orders Received and Shipped
in a Quarter
 
The volume and timing of orders received during a quarter are
difficult to forecast. Retail and retail distribution customers
generally order without forecasts on an as-needed basis and,
accordingly, the Company has historically operated with a
relatively small backlog. Moreover, the Company has emphasized its
ability to respond quickly to customer orders as part of its
competitive strategy. This strategy, combined with current
industry supply and demand conditions as well as the Company's
emphasis on minimizing inventory levels, has resulted in customers
placing orders with relatively short delivery schedules and
increased demand on the Company to carry inventory for its
customer base, particularly for large OEM customers. This has the
effect of increasing short lead-time orders as a portion of the
Company's business and reducing the Company's ability to
accurately forecast net sales. Because retail and retail
distribution customers' orders are more difficult to predict,
there can be no assurance that the combination of these orders,
OEM orders, and backlog in any quarter will be sufficient to
achieve either sequential or year-over-year growth in net sales
during that quarter. If the Company does not achieve a sufficient
level of retail and retail distribution orders in a particular
quarter, the Company's revenues and operating results would be
materially adversely affected.
 
Also, at any time and with no advance notice, during periods of
uncertainty in the personal computer industry's outlook for future
demand or pricing, the Company's customers may choose to draw down
their inventory levels thereby adversely impacting the Company's
revenue during the period of adjustment. The second and third
quarters of 1997 comprised such a period due to the transition
from older slower speed modems and 2D graphics products to new
higher speed modems and 3D graphics products. In the transition of
mainstream PC graphics subsystem architectures from 2D graphics
and the PCI bus to 3D graphics and the accelerated graphics port
(AGP), which began in 1997 and continued through 1998, controller
and memory chip selection and the timely introduction of new
products were critical factors. The Company was significantly
affected by the PCI-to-AGP transition and the SGRAM-to-SDRAM
memory transition in 1998, which resulted in significant pricing
pressures on the Company's remaining PCI-based and SGRAM-based
graphics inventory and by significant price protection claims
associated with such price declines. Due to the continual
evolution of the types of products sold by the Company, it is
probable that transitions such as these will continue to have
material and possible adverse effects on the Company's operating
results.
 
Also, as is common in the personal computer industry, a
disproportionate percentage of the Company's net sales in any
quarter may be generated in the last month or weeks of a quarter.
As a result, a shortfall in net sales in any quarter as compared
to expectations may not be identifiable until at or near the end
of the quarter. In this regard, the Company's net sales for the
second quarter of 1998 were lower than expected because of less
than expected shipments of the Monster 3D II product at the end of
that quarter due principally to sudden order cancellations during
the final week of the quarter. In addition, from time to time, a
significant portion of the Company's net sales may be derived from
a limited number of customers, the loss of one or more of which
could adversely impact operating results.
 
Notwithstanding the difficulty in forecasting future sales and the
relatively small level of backlog at any given time, the Company
generally must plan production, order components and undertake its
development, sales and marketing activities and other commitments
months in advance. Accordingly, any shortfall in net sales in a
given quarter may materially impact the Company's operating
results and cash balances in a magnified way due to the Company's
inability to adjust expenses or inventory levels during the
quarter to match the level of net sales for the quarter. Excess
inventory could also result in cash flow difficulties as well as
added costs of goods sold and expenses associated with inventory
write-offs or sell-offs. Conversely, in its efforts to adjust
inventory levels to a slower order rate, the Company may
overcorrect its component purchases and inventory levels, thereby
experiencing periodic shortages of inventory and delivery delays,
and negatively impacting its net sales, market share and customer
satisfaction levels in the current quarter or in future quarters.
There can be no assurances that such an occurrence will not
adversely impact the Company's operating results.
 
Recently, the Company 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,
the Company may not be able to react quickly enough to sudden
increases or shifts in demand for a given product with the result
that revenue may suffer in relation to expectations or in relation
to the market opportunity.
 
Declining Selling Prices and Other Factors Affecting Gross Margins
 
The Company's markets are characterized by intense ongoing
competition coupled with a past history, as well as a current
trend, of declining average selling prices. A decline in selling
prices may cause the net sales in a quarter to be lower than those
of a preceding quarter or corresponding prior year's quarter even
if more units were sold during such quarter than in the preceding
or corresponding prior year's quarter. Accordingly, it is likely
that the Company's average selling prices will decline, and that
the Company's net sales and margins may decline in the future,
from the levels experienced to date. (See also "-Short Product
Life Cycles; Dependence on New Products") The Company's gross
margins may also be adversely affected by shortages of, or higher
prices for, key components for the Company's products, including
its modems, 3D graphics accelerators, home networking adapters,
Internet music players and 3D audio accelerators, some of which
have been impacted from time-to-time by a scarcity in the supply
of associated chipsets and other components. The availability of
new products is typically restricted in volume early in a
product's life cycle and, should customers choose to wait for the
new version of a product rather than to purchase the current
version, the ability of the Company to procure sufficient volumes
of such new products to meet higher customer demand is limited.
Such a failure to meet demand for new products may have a material
adverse effect on the revenues and operating margins of the
Company.
 
In addition, the Company's net sales, average selling prices and
gross margins will be adversely affected if the market prices for
certain components used or expected to be used by the Company,
such as DRAM, SDRAM, SGRAM, RDRAM or flash memory, multimedia,
communications, or networking controller chips or bundled third-
party software applications decline more rapidly than the Company
is able to process component inventory bought earlier at higher
prices into finished products, book and ship the related orders,
and move such products through third-party distribution channels,
some of which may be price protected, to the final end-user
customer. The Company experienced such declining prices and
reduced margins in the second and third quarters of 1998 due to
the effect of product transitions, including the PCI-to-AGP
transition and the SGRAM-to-SDRAM memory transition, as well as
the effect of an oversupply of SDRAM memory in the market.
Competition from products based on SDRAM memory, which has lower
manufacturing costs than SGRAM-based products, resulted in sharply
declining selling prices for SGRAM-based products. This led to
material charges for declining inventory values and price
protection for channel inventory. These charges had a material
adverse effect on revenues, operating margins and operating
results. Conversely, an increase in the price of semiconductor
components that are in scarce supply, such as high-speed DRAMs,
may adversely impact the Company's gross margins due to higher
unit costs, and a decrease in the supply of such semiconductor
components may adversely impact the Company's net sales due to
lower unit shipments.
 
Seasonality
 
The Company believes that, due to industry seasonality, demand for
its products is strongest during the fourth quarter of each year
and is generally slower in the period from April through August.
This seasonality may become more pronounced and material in the
future to the extent that a greater proportion of the Company's
sales consist of sales into the retail/mass merchant channel, that
PCs become more consumer-oriented or entertainment-driven
products, or that the Company's net revenue becomes increasingly
based on entertainment-related products. Also, to the extent the
Company is successful in expanding its European operations, it may
experience relatively weak demand in third calendar quarters due
to historically weak summer sales in Europe.
 
Management of Growth
 
In recent years, the Company has experienced a significant
expansion in the overall level of its business and the scope of
its operations, including manufacturing, research and development,
marketing, technical support, customer service, sales and
logistics. This expansion in scope has resulted in a need for
significant investment in infrastructure, process development and
information systems. This requirement includes, without
limitation: securing adequate financial resources to successfully
integrate and manage the 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 worldwide web and e-commerce presence; consolidation
of geographically dispersed manufacturing and distribution
facilities; coordination of suppliers; rationalization of
distribution channels; establishment and documentation of business
processes and procedures; and integration of various functions and
groups of employees. Each of these requirements poses significant,
material challenges.
 
The Company completed a tender offer for Micronics Computers, Inc.
during the second quarter of 1998. In addition to managing the
changing business of the Company and its previous acquisitions,
the Company must integrate and manage the business of Micronics
with that of the Company. Furthermore, Micronics was primarily a
manufacturer of computer motherboards, a line of products that the
Company has not previously offered for sale. The Company faces
significant challenges in terms of manufacturing, engineering,
sales, marketing, and logistics with respect to integrating the
products and business of Micronics with similar functions of the
Company. There can be no assurance that the Company will be able
to successfully integrate the operations of Micronics. If the
Company fails to successfully integrate Micronics into the
operations of the Company, there will likely be a material adverse
impact on the operating results of the Company. Even if the
integration is successfully achieved, there can be no assurance
that the cost of such integration will not materially and
adversely affect the Company's operating results, or that the
Company will be able to make a satisfactory return on such costs.
 
In the fourth quarter of 1998, the Company commenced manufacturing
and shipping its first finished consumer electronics product, Rio,
a portable Internet music player. Also during the fourth quarter
of 1998, the Company commenced manufacturing and shipping the
HomeFree wireless line of home networking products. The Company
commenced manufacturing and shipping the HomeFree phoneline-based
home networking products in January 1999. These products pose new
design, manufacturing and customer support issues to the Company
and there can be no assurance that the Company can successfully
meet these challenges, generate customer demand for such products
or satisfy customer demand for the products. There can also be no
assurance that the cost associated with of meeting such challenges
and satisfying demand will not have a material adverse impact on
the Company's operating results in future periods.
 
The Company's future operating results will depend in large
measure on its success in implementing operating, manufacturing
and financial procedures and controls, improving communication and
coordination among the different operating functions, integrating
certain functions such as sales, procurement and operations,
strengthening management information and telecommunications
systems, and continuing to hire additional qualified personnel in
certain areas. Moreover, the Company has completed the first
implementation phase of a new enterprise resource planning (ERP)
system to better manage the increasing complexity of its
international multi-product business. This system, along with
subsequent planned implementation phases, also supports the
Company's efforts to avert potential Year 2000 issues with its
previous management information systems. There can be no assurance
that the Company will be able to manage these activities and
implement these additional systems, procedures and controls
successfully, and any failure to do so could have a material
adverse effect upon the Company's short-term and long-term
operating results.
 
Short Product Life Cycles; Dependence on New Products
 
The market for the Company's products is characterized by frequent
new product introductions and rapid product obsolescence. These
factors typically result in short product life cycles, frequently
ranging from six to twelve months. The Company must develop and
introduce new products in a timely manner that compete effectively
on the basis of price and performance and that address customer
requirements. To do this, the Company must continually monitor
industry trends and make difficult choices regarding the selection
of new technologies and features to incorporate into its new
products, as well as the timing of the introduction of such new
products, all of which may impair the orders for or the prices of
the Company's existing products. The success of new product
introductions depends on various factors, some of which are
outside the Company's direct control. Such factors may include:
selection of new products; selection of controller or memory chip
architectures; implementation of the appropriate standards or
protocols; timely completion and introduction of new product
designs; trade-offs between the time of first customer shipment
and the optimization of software drivers and hardware for speed,
stability and compatibility; development of supporting content by
independent software application vendors; development and
production of collateral product literature; prompt delivery to
OEM accounts of prototypes; support of OEM prototypes; ability to
rapidly ramp manufacturing volumes to meet customer demand in a
timely fashion; and coordination of advertising, press relations,
channel promotion and VAR evaluation programs with the
availability of new products. For example, selection of the
appropriate standards and protocols will be a key factor in
determining the future success of the Company's new home
networking and Internet music player products.
 
In the transition of mainstream PC graphics subsystem
architectures from 2D graphics and the PCI bus to 3D graphics and
the accelerated graphics port (AGP), which began in 1997 and
continued through 1998, controller and memory chip selection and
the timely introduction of new products have been and will
continue to be critical factors. The Company saw the effects of
the PCI-to-AGP graphics bus transition and the SGRAM-to- SDRAM
memory transition in the second and third quarters of 1998, which
resulted in significant price reductions for the Company's PCI-
based and SGRAM-based graphics inventory and the inventory of such
products in the distribution channel. As a result, the net sales
and gross margins of the Company were materially and adversely
affected by declining prices for the PCI-based and SGRAM-based
products, and there were significant price protection claims
associated with such price declines. In the transition from the
proprietary K56flex and x2 protocols (56Kbps) to the international
standard V.90 protocol (56Kbps), the chip selection to implement
and deploy such standard and the industry alliances to generate
revenue and market share have been critical factors. The Company
currently faces similar standards-setting issues in the areas of
home networking, broadband modems and Internet audio. There can be
no assurance that the Company will select the proper chips,
software and protocols to implement and support its efforts in
developing new products or targeting new markets or that the
Company will execute its strategies in a timely manner.
 
Each new product cycle presents new opportunities for current or
prospective competitors of the Company to gain a product advantage
or increase their market share. If the Company does not
successfully introduce new products within a given product cycle,
the Company's sales will be adversely affected for that cycle and
possibly for subsequent cycles. Any such failure could also impair
the Company's brand name and ability to command retail shelf space
and OEM design wins in future periods. Moreover, because of the
short product life cycles coupled with the long lead times for
procuring many of the components used in the Company's products,
the Company may not be able, in a timely manner, or at all, to
reduce its component procurement commitments, software license
commitments, production rates or inventory levels in response to
unexpected delays in product launch, shortfalls in sales,
technological obsolescence or declines in prices or, conversely,
to increase production in response to unexpected increases in
demand, particularly if such demand increases are in a new product
or new technology area where component supply may be hard to
secure. Therefore, changes in actual or expected demand could
result in excess inventory, inventory write downs, price
protection and gross margin compression or, conversely, in lost
sales and revenue compression due to product or component
unavailability. For example, the timing and speed of the PCI-to-
AGP bus transition and the SGRAM-to-SDRAM memory transition led to
an excess inventory of PCI and SGRAM-based products at the Company
and in the distribution channel which in turn resulted in lower
average selling prices, lower gross margins, end-of-life inventory
write-offs, and higher price protection charges during the second
and third quarters of 1998. Further, the falling demand for and
excess supply of Monster 3D II and competitive 3D gaming products
in the channel during the third quarter of 1998 resulted in
rapidly declining revenue and prices vis-a-vis the second quarter
of 1998, and the resulting price protection for this class of
product in the third quarter of 1998. The Company estimates and
accrues for potential inventory write-offs and price protection
charges. There can be no assurance that these estimates and
accruals will be sufficient in future periods, or that additional
inventory write-offs and price protection charges will not be
required. The impact of these charges on the Company's operating
results in 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.
 
New Operating Systems
 
The PC industry has been characterized by significant operating
system changes, such as the introduction of Windows 95 in 1995 and
Windows NT 4.0 in 1996, and the introduction of significant new
operating system components, such as Microsoft's Direct X and
ActiveX for Windows 95. During the second quarter of 1998,
Microsoft introduced Windows 98. In anticipation of the release of
Windows 98 a significant portion of new computer purchasers
delayed purchase of a new system until after the release of
Windows 98. The effects of this consumer resistance were
compounded by the delay and uncertainty of the release due to
legal challenges. Additionally, further purchases were delayed to
ensure that the new operating system would be compatible with
older applications and would operate at least as reliably as
Windows 95. The Company believes that this forward shift in time
of a significant number of computer purchasers had an adverse
impact on the revenues of the Company in the second quarter of
1998.
 
In addition, while new operating systems can provide new market
opportunities, such as the growing market for graphical user
interface (GUI) accelerators that occurred with the introduction
of Windows 3.0 and the growth in the PC games market with the
introduction of Windows 95, new operating systems and operating
system components also place a significant research and
development burden on the Company. New drivers, applications and
user interfaces must be developed for new operating systems and
operating system components in order to maintain net sales levels
and customer satisfaction. Perhaps more significantly, such
drivers, applications and interfaces customarily are ported to the
recently shipped portion of the Company's installed base. This
effort involves a substantial investment in software engineering,
compatibility testing and customer technical support with only
limited near-term incremental revenue return since these driver
updates are usually provided via electronic distribution at no
cost to the Company's installed customer base. In addition, the
installation of this software may result in technical support
calls, thereby generating expenses that do not have offsetting
revenue. Moreover, during the introductory period of a major new
operating system release such as Windows 95 or Windows 98, such
installed base support may reduce the research and development and
customer technical support resources available for launching new
products. For example, after substantial investment in porting the
Company's software, graphics accelerator and modem products to
Windows 95, the Company was at year-end 1996 still developing for
final release improved, accelerated Windows 95 drivers for the
Viper Pro Video series of accelerator add-in cards. While this
product line did not at that time represent a revenue opportunity
for the Company, the Company nevertheless believed that it was
important to make the significant software development investment
represented by this effort in order to maintain relations with its
installed customer base and its reputation for reliable on-going
product support. Furthermore, new operating systems for which the
Company prospectively develops driver support may not be
successful, or the drivers themselves may not be successful or
accepted by customers, and a reasonable financial return on the
corollary research and development investment may never be
achieved.
 
Dependence on Third Party Software Developers
 
The Company's business strategy includes developing relationships
with major independent software application vendors that serve the
3D graphics and 3D audio markets, including the 3D computer games
market and the professional 3D graphics applications market. The
Company believes that the availability of a sufficient number of
high quality, commercially successful entertainment 3D software
titles will be a significant factor in the sale of multimedia
hardware to the PC-based interactive 3D entertainment market. The
Company also believes that compelling professional 3D graphics
applications developed for PCs or ported from traditional UNIX-
based workstations, such as those supplied by Silicon Graphics,
IBM and Sun Microsystems, to PCs based on advanced Intel
microprocessors and the Microsoft NT operating system will be
significant factors in the sale of 3D graphics hardware to the PC-
based NT workstation market. The Company depends on independent
software application developers and publishers to create, produce
and market software entertainment titles and professional graphics
applications that will operate with the Company's 3D products,
such as the Viper and Fire GL series of graphics accelerators.
Only a limited number of software developers are capable of
creating high quality professional 3D and entertainment 3D
software. Competition for these resources is intense and is
expected to increase. There can be no assurance that the Company
will be able to attract the number and quality of software
developers and publishers necessary to develop a sufficient number
of high quality, commercially successful software titles and
applications that are compatible with the Company's 3D graphics
and audio platforms.
 
Further, in the case of the Company's entertainment 3D products,
there can be no assurance that third parties will publish a
substantial number of entertainment 3D software titles or, if
entertainment 3D software titles are available, that they will be
of high quality or that they will achieve market acceptance. The
development and marketing of game titles that do not fully
demonstrate the technical capabilities of the Company's
entertainment 3D products could create the impression that the
Company's products offer less compelling performance over
competing 3D graphics accelerators or 3D games platforms, such as
TV games consoles. This may slow or stop any migration from the
current widespread use of TV games consoles to the use of computer
games on PCs, or the enhancement of PCs to operate such games.
Further, because the Company has no control over the content of
the entertainment titles produced by software developers and
publishers, the entertainment 3D software titles developed may
represent only a limited number of game categories vis-a-vis those
available for TV game consoles and are likely to be of varying
quality.
 
Semiconductor or Software Defects
 
Product components may contain undetected errors or "bugs" when
first supplied to the Company that, despite testing by the
Company, are discovered only after certain of the Company's
products have been installed and used by customers. There can be
no assurance that errors will not be found in the Company's
products due to errors in such products' components, or that any
such errors will not impair the market acceptance of these
products or require significant product recalls. Problems
encountered by customers or product recalls could materially
adversely affect the Company's business, financial condition and
results of operations.  Further, the Company continues to upgrade
the firmware, software drivers and software utilities that are
incorporated into or included with its hardware products. The
Company's software products, and its hardware products
incorporating such software, are extremely complex due to a number
of factors, including the products' advanced functionality, the
diverse operating environments in which the products may be
deployed, the rapid pace of technology development and change in
the Company's target product categories, the need for
interoperability, and the multiple versions of such products that
must be supported for diverse operating platforms, languages and
standards. These products may contain undetected errors or
failures when first introduced or as new versions are released.
The Company generally provides a five-year warranty for its
products and, in general, the Company's return policies permit
return for full credit within thirty days after receipt of
products that do not meet product specifications. There can be no
assurance that, despite testing by the Company, by its suppliers
and by current or potential customers, errors will not be found in
new products after commencement of commercial shipments, resulting
in loss of or delay in market acceptance or product acceptance or
in warranty returns. Such loss or delay would likely have a
material adverse effect on the Company's business, financial
condition and results of operations.
 
Additionally, new versions or upgrades to operating systems,
independent software vendor titles or applications may require
upgrades to the Company's software products to maintain
compatibility with such new versions or upgrades. There can be no
assurance that the Company will be successful in developing new
versions or enhancements to its software or that the Company will
not experience delays in the upgrade of its software products. In
the event that the Company experiences delays or is unable to
maintain compatibility with operating systems and independent
software vendor titles or applications, the Company's business,
financial condition and results of operations could be materially
adversely affected.
 
Market Anticipation of New Products, New Technologies or Lower
Prices
 
Since the environment in which the Company operates is
characterized by rapid new product and technology introductions
and generally declining prices for existing products, the
Company's customers may from time to time postpone purchases in
anticipation of such new product introductions or lower prices. If
such anticipated changes are viewed as significant by the market,
such as the introduction of a new operating system or
microprocessor architecture, then this may have the effect of
temporarily slowing overall market demand and negatively impacting
the Company's operating results. For example, the substantial pre-
release publicity surrounding the release of Windows 95 may have
contributed to a slowing of the consumer PC market in the summer
of 1995. Moreover, a similar reaction occurred in the modem market
as a result of the announcements of modems based on 56 Kbps
technology, which became available in 1997, and in the overall PC
market in anticipation of Intel Corporation's transition to MMX-
based microprocessors during 1997. Additionally, the substantial
publicity by Intel Corporation for its MMX technology may have
confused and slowed the market for add-in multimedia accelerators,
such as those sold by the Company, during the first half of 1997.
Similarly, Microsoft's launch of Windows 98 combined with the
uncertainties surrounding such a launch was a factor in slower PC
sales in the second quarter of 1998. These effects may continue
into future periods for these or similar events. Other new product
releases that may influence future market growth or the timing of
such growth include Intel's release of its Pentium III CPU and the
associated chipsets supporting the 2x AGP and 4x AGP
architectures, Intel's release of its "Merced" workstation CPU,
and the anticipated release of Microsoft's Windows 2000. Further,
slippage in the actual volume shipment of such new products could
have the effect of prolonging any market slowdown due to the
anticipation of the new products.
 
The potential negative impact on the Company's operating results
as a result of customer decisions to postpone purchases in favor
of new and "publicized" technologies, including the Company's own
new technologies, can be further magnified if products or
components based on such new technology are not available in a
timely manner or in sufficient supply to meet the demand caused by
the market's shift to the new technology from an older technology.
For example, the Company believes that the PC market may have
slowed in early 1997 in part as customers waited for the
availability of Intel's new MMX-enabled Pentium CPUs. Further, the
Company's operating results could be adversely affected if the
Company makes poor selections of chip architectures or chip
suppliers to pursue 3D graphics, AGP or 56Kbps modem market
opportunities and, as a result, is unable to achieve market
acceptance of its new products or is unable to secure a sufficient
supply of such components.
 
If the Company or any of its competitors were to announce a
product that the market viewed as having more desirable features
or pricing than the Company's existing products, demand for the
Company's existing products could be curtailed, even though the
new product is not yet available. For example, in the second
quarter of 1998, the Company's next-generation SDRAM-based
graphics accelerators had a memory cost component roughly half
that of SGRAM-based graphics accelerators. Market anticipation of
new product releases such as these, as well as similar competitive
releases, reduced demand for the Company's SGRAM based graphics
products and materially and adversely affected the Company's
operating results for the second and third quarters of 1998.
Similar results may occur during the second quarter of 1999 as the
market anticipates new 32-megabyte graphics accelerators.
Similarly, if the Company's customers anticipate that the Company
may reduce its prices in the near term, they might postpone their
purchases until such price reductions are effected, reducing the
Company's near-term shipments and revenue. In general, market
anticipation of new products, new technologies or lower prices,
although potentially positive in the longer term, can negatively
impact the Company's operating results in the short term. This
factor constitutes an exceptionally difficult-to- manage
characteristic of the Company's graphics business due to the rapid
six-month product cycles that typify the current 3D graphics
market.
 
Component Shortages; Reliance on Sole or Limited Source Suppliers
 
The Company is dependent on sole or limited source suppliers for
certain key components used in its products, particularly chipsets
and software that provide graphics, digital video, DVD, television
(TV), sound or other multimedia functions, random access memory
(including DRAM, RDRAM, SDRAM, SGRAM and flash) chips, and
speakerphone/modem and softmodem chipsets and algorithms. Although
the price and availability of many semiconductor components
improved during 1997 and 1998, these components are periodically
in short supply and on allocation by semiconductor manufacturers.
For example, it is expected that the Company may experience
constraints in the supply of high-performance SGRAMs, SDRAMs and
flash memory and new technology, high-performance 3D graphics
chips for the foreseeable future.  There can be no assurances that
the Company can obtain adequate supplies of such components, or
that such shortages or the costs of these components will not
adversely affect future operating results. The Company's
dependence on sole or limited source suppliers, and the risks
associated with any delay or shortfall in supply, can be
exacerbated by the short life cycles that characterize multimedia
and communications ASIC chipsets and the Company's products in
general. Although the Company maintains ongoing efforts to obtain
required supplies of components, including working closely with
vendors and periodically qualifying alternative components for
inclusion in the Company's products, component shortages continue
to exist from time to time, and there can be no assurances that
the Company can continue to obtain adequate supplies or obtain
such supplies at their historical or competitive cost levels.
Further, the Company has as an objective to reduce the number of
chip architecture suppliers with which it works, potentially
raising "single-source" supply risks. Conversely, in its attempt
to counter actual or perceived component shortages, the Company
may over-purchase certain components or pay unnecessary expediting
or other surcharges, resulting in excess inventory or inventory at
higher than normal costs and reducing the Company's liquidity, or
in the event of unexpected inventory obsolescence or a decline in
the market value of such inventory, causing inventory write-offs
or sell-offs that adversely affect the Company's gross margin and
profitability. Such a condition existed in the first quarter of
1998, and the Company's perception of component shortages caused
the Company to over purchase components and pay surcharges for
components that subsequently declined in value in the second,
third and fourth quarters of 1998. In addition, such inventory
sell-offs by the Company or its competitors could trigger channel
price protection charges, further reducing the Company's gross
margins and profitability, such as occurred with the Monster 3D II
product line in the third and fourth quarters of 1998.
 
As noted above, supply and demand conditions for semiconductor
components are unpredictable and may change from time to time.
During periods of oversupply, prices are likely to fall and
certain vendors of such semiconductor chips may liquidate their
inventories in a rapid manner. If such semiconductor vendors are
suppliers to the Company's competitors, then such actions could
enable competitors of the Company to enjoy a cost advantage vis-a-
vis the Company, and any resulting price reduction for such
competitors' products could force the Company to reduce its
prices, thereby depressing the Company's net sales and gross
margins in one or more operating periods.
 
During periods of component oversupply and associated price
deflation, customers of the Company, particularly those comprising
channels that do not receive price protection from the Company,
may seek to draw down the inventory that they hold since such
inventory likely would bear a price deflation risk. As a
consequence, the Company may see its orders, unit shipments or
average selling prices depressed from time to time during such
price-deflation and inventory-reduction periods. This occurred
during the second and third quarters of 1998, which adversely
affected net sales and gross margin during such periods, and this
may occur again in future periods.
 
When the PC or PC peripherals markets emerge from a period of
oversupply, such as that experienced in the second quarters of
1997 and 1998, certain manufacturers, distributors and resellers
may be unprepared for a possible rapid increase in market demand.
Accordingly, the Company may not have sufficient inventory,
scheduled component purchase orders or available manufacturing
capacity to meet any rapid increase in market demand, thereby
missing orders and revenue opportunities, causing customer
dissatisfaction and losing market share. The Company experienced
such a situation in the second half of 1997 and in the second half
of 1998 as the Company experienced a shortage of various
components, restricting the Company's ability to manufacture
certain products in sufficient quantities or in a linear fashion
to meet market demand. In addition, the Company believes that in
the near term the Company will continue to be subjected to
restricted supply and increasing prices on certain semiconductor
components including newly introduced graphics controllers and
random access memories.  The inability of the Company to obtain
product components at their historical or planned cost levels,
resulting in the Company being forced to pay higher prices to
achieve timely delivery, would directly affect the cost of the
Company's products and could materially and adversely affect the
Company's gross margin. There can be no assurance that the Company
will be able to obtain adequate supplies of components or that
such shortages or the costs of these components will not adversely
impact the Company's future operating results. Conversely, there
can be no assurance that the Company will not see the value of its
inventory depreciate if components in a shortage condition emerge
from that condition and experience a significant oversupply
condition. For example, this situation occurred during the second
and third quarters of 1998 with certain graphics chips that
support only SGRAM memory, and in the third and fourth quarters of
1998 with components associated with the Company's Monster 3D II
product line.
 
Dependence on Subcontractors
 
The Company relies on independent surface mount technology ("SMT")
subcontractors to manufacture, assemble or test the Company's
board level products, as well as its first "finished" consumer
electronics product, Rio, an Internet music player. The Company
typically procures its components, assembly and test services and
assembled products through purchase orders and does not have
specific volume purchase agreements with each of its
subcontractors. Most of the Company's subcontractors could cease
supplying the services, products or components at any time with
limited or no penalty. In the event that it becomes necessary for
the Company to replace a key subcontractor, the Company could
incur significant manufacturing set-up costs and delays. There can
be no assurance that the Company would be able to find suitable
replacement subcontractors. The Company's emphasis on maintaining
low internal and channel inventory levels may exacerbate the
effects of any shortage that may result from the use of sole-
source subcontractors during periods of tight supply or rapid
order growth. The Company's ability to respond to greater than
anticipated market demand may be constrained by the availability
of SMT or finished product subcontracting services. Further,
various of the Company's subcontractors are located in
international locations that, while offering low labor costs, may
present heightened process control, quality control, political,
infrastructure, transportation, tariff, regulatory, legal, import,
export, economic or supply chain management risks.
 
Dependence on Graphics and Multimedia Accelerator Market
 
Sales of graphics and video accelerator subsystems accounted for
greater than 77% and 75% of the Company's net sales in 1998 and
1997, respectively, and 54% in the first quarter of 1999.
Although the Company has introduced audio subsystems, has entered
the PC modem and home networking markets, and has entered into the
PC consumer electronics market with its Rio Internet music player,
graphics and video accelerator subsystems are expected to continue
to account for a majority of the Company's sales for the
foreseeable future. A decline in demand or average selling prices
for graphics and video accelerator subsystems, whether as a result
of new competitive product introductions, price competition,
excess supply, widespread cost reduction, technological change,
incorporation of the products' functionality onto personal
computer motherboards or otherwise, would have a material adverse
effect on the Company's sales and operating results.
 
Migration to Personal Computer Motherboards
 
The Company's graphics and multimedia accelerator subsystems are
individual products that function within personal computers to
provide additional multimedia functionality. Historically, as a
given functionality becomes technologically stable and widely
accepted by personal computer users, the cost of providing such
functionality is typically reduced by means of large scale
integration into semiconductor chips, which can be subsequently
incorporated onto personal computer motherboards. While the
Company expects that such migration will not occur in a
substantial way with 3D graphics or Intel's accelerated graphics
port (AGP) in the near term due to the new, rapidly changing
technologies in these areas, the Company recognizes that such
migration could occur with respect to the functionality provided
by some of the Company's current products, and with 3D graphics
and the AGP bus over the longer term. While the Company believes
that a market will continue to exist for add-in subsystems that
provide advanced or multiple functions and offer flexibility in
systems and connectivity configuration, such as 3D graphics, 3D
audio, and communications, there can be no assurance that the
incorporation of new multimedia functions onto personal computer
motherboards or into CPU microprocessors, such as under Intel's
MMX, Whitney or AGP technologies, will not adversely affect the
future market for the Company's products. In large part, the
continuation of a robust market for add-in graphics and video
subsystems may depend on the timing and market acceptance of 3D
graphics and digital video acceleration. This, in turn, may depend
on the availability of compelling 3D and digital video content,
including games and entertainment, broadcast digital video, PC
videophones, desktop video conferencing, and digital video, audio
and 3D VRML graphics on the Internet.  Similarly, the robustness
of the communications market may depend largely on the widespread
adoption of digital subscriber line (xDSL) and cable modem
technologies in both client-side modems attached to the PC and
server-side modems provided by Internet Service Providers and
telephone network central offices, and the emergence of a robust,
growing home networking market. The timing of major xDSL, cable
modem and home networking technology introductions, and the market
acceptance of these new technologies and standards, are beyondthe
control of the Company.
 
The Company believes that a large portion of the growth in the
sales of personal computers may be in sealed systems which contain
most functionality on a single systems board and are not able to
be upgraded in the manner most current personal computers can be
upgraded. These sealed computers would contain a systems board
that could include CPU, system memory, graphics, audio, and
connectivity functionality on a single board.  The Company
recently acquired Micronics for the purpose of obtaining technical
and marketing expertise and brand acceptance in CPU motherboard
design and to develop integrated multimedia system board products.
However, there can be no assurance that a significant market will
exist for low-cost fixed system boards or that the acquisition of
Micronics will enable the Company to successfully compete in such
an emerging market or in the current motherboard market.
 
Risks Associated with Industry Consolidation
 
The Company pursues a strategy of "silicon agility" which entails
continuous evaluation of outside sources of graphics, modem, home
networking, and audio chipsets. This strategy depends on a number
of competitive suppliers of each of these products in order to
ensure that the Company is offering leading edge technology in
each product line at prices with which the Company can compete
with competitors who design their own chipsets. In the recent past
there have been instances of chipset suppliers acquiring their own
add-in card manufacturing, marketing and distribution (for
example, Evans & Sutherland Corp's purchase of Accel Graphics,
3Dfx's purchase of STB Systems, or the 3Dlabs Inc. acquisition of
Dynamic Pictures Inc.). While these acquisitions in and of
themselves are not material to the operations of the Company,
vertical integration acquisitions restrict the choices of chipset
suppliers available to the Company and thereby may reduce the
likelihood that the Company will have access to leading edge
technology at prices which allow the Company to compete with
vertically integrated competitors such as ATI Technologies Inc.,
Matrox Graphics Inc., 3Com Corporation, and Creative Technologies,
Inc.
 
Competition
 
The market for the Company's products is highly competitive. The
Company competes directly against a large number of suppliers of
multimedia and connectivity products for the PC such as Matrox
Graphics Inc., 3Dfx, Creative Technologies Inc., 3Com Corporation,
and ATI Technologies Inc., and indirectly against PC systems OEMs
to the extent that they manufacture their own add-in subsystems or
incorporate on PC motherboards the functionality provided by the
Company's products. In certain markets where the Company is a
relatively new entrant, such as modems, home networking, sound
cards, and consumer electronics Internet music players, the
Company may face dominant competitors including 3Com (home
networking and modems), Creative Technologies, Inc. (sound cards,
modems and Internet music players), Intel (home networking) and
Sony Corp. (consumer electronic music players). In addition, the
Company's markets are expected to become increasingly competitive
as multimedia functions continue to converge and companies that
previously supplied products providing distinct functions (for
example, companies today primarily in the sound, modem, CPU or
motherboard markets) emerge as competitors across broader or more
integrated product categories.
 
In addition, manufacturers of chipsets or other components used in
the Company's products could become future competitors of the
Company to the extent that such manufacturers elect to integrate
forward into the add-in subsystem or value-added software market
(for example, the acquisition of STB Systems by 3Dfx), or as
multimedia chipset manufacturers provide increasingly higher
quality and more sophisticated software to their chipset
customers, including subsystem suppliers competitive to the
Company. Also, certain of the Company's current and potential
competitors have significantly greater market presence, name
recognition and financial and technical resources relative to the
Company, and many have long- standing market positions and
established brand names in their respective markets. In addition,
certain of the Company's current and potential competitors also
have a competitive cost advantage as a result of being located in
areas that impose significantly lower taxes than the United States
or offer a substantially lower cost of labor or provide
governmental subsidies, such as research and development and
training funds. Many of the Company's current and potential
competitors also design and manufacture their own graphics, video,
sound, modem, home networking, or other multimedia and
connectivity processing chipsets. While the Company believes that
its semiconductor vendor flexibility enables it to select, within
certain limits, from among the most advanced and price competitive
chipsets available on the open market, the captive semiconductor
operations of certain of the Company's current and potential
competitors could provide them with significant advantages,
including greater control over semiconductor architecture and
technology, component design, component performance, systems and
software design, time to market, availability and cost.
 
The Company also believes that the strategy of certain of its
current and potential competitors is to compete largely on the
basis of price, which may result in lower prices and lower margins
for the Company's products or otherwise adversely affect the
market for the Company's products. To the extent that
semiconductor availability is relatively robust and software
drivers and reference hardware designs from multimedia chipset
manufacturers are of high quality and sophistication, then
competitors who sell such reference designs and compete largely on
price with little value-added engineering may have a competitive
cost or expense advantage relative to the Company. There can be no
assurance that the Company will be able to continue to compete
successfully in its current and future markets, or will be able to
compete successfully against current and new competitors, as the
Company's technology, markets and products continue to evolve.
 
Distribution Risks
 
The Company sells its products through a network of domestic and
international distributors, and directly to major retailers/mass
merchants, VARs and OEM customers. The Company's future success is
dependent on the continued viability and financial stability of
its customer base. The computer distribution and retail channels
historically have been characterized by rapid change, including
periods of widespread financial difficulties and consolidation and
the emergence of alternative sales channels, such as direct mail
order, telephone sales by PC manufacturers and electronic commerce
on the worldwide web. The loss of, or reduction in, sales to
certain of the Company's key customers as a result of changing
market conditions, competition, or customer credit problems could
have a material adverse effect on the Company's operating results.
Likewise, changes in distribution channel patterns, such as
increased commerce on the Internet, increased use of mail-order
catalogues, increased use of consumer-electronics channels for
personal computer sales, or increased use of channel assembly to
configure PC systems to fit customers' requirements could affect
the Company in ways not yet known. For example, the rapid
emergence of Internet-based e-commerce is putting substantial
strain on some of the Company's traditional channels. Moreover,
additions to or changes in the types of products the Company
sells, such as the introduction of professional-grade products or
the migration toward more communications-centric products, such as
home networking, may require specialized value-added reseller
channels, relations with which the Company has only begun to
establish.
 
Inventory levels of the Company's products in the two-tier
distribution channels used by the Company ("Channel Inventory
Levels") generally are maintained in a range of one to two months
of customer demand. Channel Inventory Levels tend toward the low
end of the months-of-supply range when demand is stronger, sales
are higher and products are in short supply.  Conversely, when
demand is slower, sales are lower and products are abundant, then
Channel Inventory Levels tend toward the high end of the months-
of-supply range. Frequently, in such situations, the Company
attempts to ensure that distributors devote their working capital,
sales and logistics resources to the Company's products to a
greater degree than to those of competitors. Similarly, the
Company's competitors attempt to ensure that their own products
are receiving a disproportionately higher share of the
distributors' working capital and logistics resources. In an
environment of slower demand and abundant supply of products,
price declines are more likely to occur and, should they occur,
are more likely to be severe. Further, in such an event, high
Channel Inventory Levels may result in substantial price
protection charges. Such price protection charges have the effect
of reducing net sales and gross profit. Consequently, the Company,
in taking steps to bring its Channel Inventory Levels down to a
more desirable level, may cause a shortfall in net sales during
one or more accounting periods. This was the case in the third
quarter of 1998 as the company reduced channel inventory levels as
part of its new short-cycle inventory model. While this is
expected to reduce the Company's exposure to future charges for
price protection and excess inventory, it materially and adversely
affected revenues for the third and fourth quarters. Such efforts
to reduce channel inventory might also result in price protection
charges if prices are decreased to move product out to final
consumers, having an adverse impact on operating results. While
the Company believes that its Channel Inventory Levels for many of
its products are appropriate at this time, there are certain
products which have a Channel Inventory Level that is higher than
desirable. The Company accrues for potential price protection
charges on unsold channel inventory.  However, there can be no
assurance that any estimates, reserves or accruals will be
sufficient or that any future price reductions will not have a
material adverse effect on operating results.
 
Product Returns; Price Protection
 
The Company frequently grants limited rights to customers to
return certain unsold inventories of the Company's products in
exchange for new purchases ("Stock Rotation"), as well as price
protection on unsold inventory. Moreover, certain of the Company's
retail customers will readily accept returned products from their
own retail customers, and these returned products are, in turn,
returned to the Company for credit. The Company estimates returns
and potential price protection on unsold channel inventory. The
Company accrues reserves for estimated returns, including warranty
returns, and price protection, and since the fourth quarter of
1998, reserves the gross margin associated with channel inventory
levels that exceed four weeks of demand. The Company experienced
significant price protection charges due to the transition from
PCI to AGP-based graphics accelerators and from SGRAM to SDRAM-
based graphics accelerators during the second, third and fourth
quarters of 1998. Moreover, the Company experienced significant
price and revenue erosion and associated price protection on its
Monster 3D II product line in the third and fourth quarter of 1998
as demand for that class of product declined, and market prices
also declined significantly. The Company may be faced with further
significant price protection charges as the Company and its
competitors move to reduce channel inventory levels of current
products, such as the Viper V550, as new product introductions are
made. However, there can be no assurance that any estimates,
reserves or accruals will be sufficient or that any future returns
or price reductions will not have a material adverse effect on
operating results, including through the mechanisms of Stock
Rotation or price protection, particularly in light of the rapid
product obsolescence which often occurs during product
transitions. The short product life cycles of the Company's
products, the evolving markets for new multimedia and connectivity
technologies such as cable or xDSL modems, 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 the Company or its competitors,
or other factors affecting the personal computer and add-in
subsystems industry could result in significant and unforeseen
product returns, with such returns creating a material adverse
effect on the Company's financial performance. In addition, there
can be no assurance that new product introductions by competitors,
particularly in the rapidly changing market for Internet
appliances, or other market factors, such as the integration of
graphics and video acceleration by OEMs onto system motherboards,
will not require the Company to reduce prices in a manner or at a
time that gives rise to significant price protection charges and
has a material adverse impact upon the Company's gross margins.
 
Furthermore, the markets that the Company serves include end users
that buy from computer retail and consumer electronics mass
merchant outlets to upgrade their existing PCs. Such customers
frequently decide to return products to the retail outlets from
which they earlier purchased the product. Such returns are made
for a variety of reasons, including the customer changing his or
her mind regarding his or her purchase decision, the customer
having difficulty with the installation or use of the product, the
product not offering the features, functions, or performance that
the customer expected or the customer experiencing
incompatibilities between the product and his or her existing PC
hardware or software. Since many of the products that the Company
sells incorporate advanced computer technology, the Company
expects that end-user customer returns, including warranty
returns, will be a continuing negative attribute of supplying to
the PC installed-base upgrade market. There can be no assurance
that the Company will be able to achieve gross margins in the PC
installed-base upgrade market that will be high enough to offset
the expenses of end-user customer returns and still generate an
acceptable return on sales to the Company.
 
OEM Customer Risks
 
The Company currently has a limited number of OEM customers. While
the Company is seeking to increase its sales to OEMs, certain OEMs
maintain internal add-in subsystem design and manufacturing
capabilities or have long-standing relationships with competitors
of the Company, and there can be no assurance that the Company
will be successful in its efforts to increase its OEM sales.
Moreover, developing supplier relationships with major PC systems
OEMs and installing the processes, procedures and controls
required by such OEMs can be an expensive and time-consuming
process, and there can be no assurance that the Company will
achieve an acceptable financial return on this investment.
Further, to the extent that PC systems OEMs selection criteria are
weighted toward multimedia subsystem suppliers that have their own
captive SMT manufacturing operations, then the Company's sole
reliance on outside SMT subcontract manufacturers may be a
negative factor in winning such PC systems suppliers' OEM
contracts.
 
It is expected that OEM revenue will carry a lower gross margin
percentage compared to sales to other channels due to perceived
lower expenses to support such OEM revenue and the buying power
exercised by large OEMs. Furthermore, many large OEMs require that
distribution hubs be established local to their factories to
supply such factories on very short notice. Such hubs represent a
cash drain on the Company to support the required inventory, and a
product obsolescence and inventory write-off risk as the price of
such inventory may decline or reach the end of its useful life or
the design-in life at the OEM before such inventory, which may be
specific to a certain OEM, is completely consumed.  The Company's
contractual relationships with Dell, Micron and Compaq regarding
such hubs may represent such product obsolescence and inventory
write-off risks.
 
The Company's products are priced for and generally aimed at the
higher performance and higher quality segment of the market.
Therefore, to the extent that OEMs focus on low-cost solutions
rather than high-performance solutions, an increase in the
proportion of the Company's sales to OEMs may result in an
increase in the proportion of the Company's revenue that is
generated by lower-selling-price and lower-gross-margin products,
particularly with respect to the Company's audio and modem
products, which could adversely affect future gross margins and
operating results of the Company.
 
Rapid Technological Change
 
The markets for the Company's products are characterized by
rapidly changing technology, evolving industry standards, frequent
new product introductions and rapid product obsolescence. For
example, 3D technology is evolving rapidly in the graphics and
audio markets, memory architectures and speeds are changing
rapidly, and DVD and MPEG-2 decryption techniques and navigation
technologies are still being refined and moving from hardware-
centric to software-centric implementations. Product life cycles
in the Company's markets frequently range from six to twelve
months. The Company's success will be substantially dependent upon
its ability to continue to develop and introduce competitive
products and technologies on a timely basis with features and
functions that meet changing customer requirements in a cost-
effective manner. Further, if the Company is successful in the
development and market introduction of new products, it must still
correctly forecast customer demand for such new products so as to
avoid either excessive unsold inventory or excessive unfilled
orders related to the products. The task of forecasting such
customer demand is unusually difficult for new products, for which
there is little sales history, and for indirect channels, where
the Company's customers are not the final end customers. Moreover,
whenever the Company launches new products, it must also
successfully manage the corollary obsolescence and price erosion
of those of its older products that are impacted by such new
products, as well as any resulting price protection charges and
Stock Rotations from its distribution channels. During the second
quarter of 1998, the Company experienced large price protection
charges with respect to the decline in average selling prices of
graphics accelerators due to the SGRAM to SDRAM transition of
mainstream graphics accelerators and other competitive pressures.
Due to the much lower cost of SDRAM solutions SGRAM prices fell in
competition thereby lowering manufacturing costs of graphics
accelerators. The Company, forced to meet the pricing actions of
its competitors, lowered prices, triggering larger than normal or
expected price protection and eroding the value of some of the
Company's on hand inventory. A similar phenomenon occurred in the
third and fourth quarters of 1998 relative to the Company's
Monster 3D II product line.
 
Risks of International Sales
 
The Company's international sales are subject to a number of risks
generally associated with international business operations,
including the effect on demand for the Company's products in
international markets as a result of a strengthening or weakening
U.S. dollar, the effect of currency fluctuations on consolidated
multinational financial results, any state- imposed restrictions
on the repatriation of funds, any import and export duties and
restrictions, certain international economic conditions, the
expenses, time and technical resources required to localize the
Company's various products and to support local languages, the
logistical difficulties of managing multinational operations and
dispersed product inventory designed or manufactured to meet
specific countries' requirements, and the delays and expenses
associated with homologating the Company's telecommunications
products and securing the necessary governmental approvals for
shipment to various countries.
 
The Company's international sales can also be affected if
inventory sold by the Company to its international distributors
and OEMs and held by them or their customers does not sell through
to final end customers, which may impact international distributor
or OEM orders in the succeeding periods. The Company believes that
it generally has less information with respect to the inventory
levels held by its international OEMs and distributors as compared
to their domestic counterparts, and that the supply chain to such
international customers is longer, and that therefore the Company
generally has less visibility on how this held inventory might
affect future orders to and sales by the Company. In the event
that international OEMs or distributors change their desired
inventory levels, there can be no assurance that the Company's net
sales to such customers will not decline at such time or in future
periods, or that the Company will not incur price protection
charges with respect to such customers.
 
During the first three quarters of 1998, sales in Asia and
Southeast Asia were below expected levels. The lack of sales in
the Asian market were primarily related to the lack of credit
facilities available to customers in those markets for the
Company's products and other products necessary for those
customers to sell complete products. While Asian markets have
begun to recover, the Company expects continued volatility and
sluggishness in sales to Asia and Southeast Asia during 1999 as
well as very slow sales to Latin America for the foreseeable
future.
 
Information Technology and Telecommunications Systems
 
The Company is currently making significant investments in
establishing systems, processes and procedures to more efficiently
and effectively manage its worldwide business and enable
communications and data sharing among its employees and various
business units. This effort comprises a significant investment of
expense and capital funds, as well as a drain on management
resources, for the installation of information technology ("IT"),
network and telecommunications equipment and IT applications. As
part of this program to install IT systems throughout the Company,
management has begun installation of an enhanced enterprise-wide
business management, resource planning and decision support
application. Further, in order to more effectively manage the
Company's business and avert Year 2000 issues, the Company is
implementing this new ERP application and the associated processes
and procedures and installing the associated IT equipment in order
for it to be fully operational no later than by the middle of
1999. Associated with this, the Company is implementing e-comerce,
product data management and customer support system upgrades. Such
efforts are expected to comprise a further substantial investment
of capital, expenses and management resources by the Company.
 
Year 2000 Compliance
 
Many existing computer systems and applications, as well as
numerous embedded control devices, use only two digits to identify
a year in the date field without considering the impact of the
upcoming change in the century. As a result, such systems,
applications or control devices could fail or create erroneous
results unless corrected so that they can process data related to
the year 2000. The Company relies on its systems, applications and
devices in operating and monitoring all major aspects of its
business, including financial systems (such as general ledger,
accounts payable and payroll modules), customer services,
infrastructure, embedded computer chips, networks and
telecommunications equipment and end products. The Company also
relies, directly and indirectly, on external systems of business
enterprises such as customers, suppliers, creditors, financial
organizations, and of governmental entities, both domestic and
international, for accurate exchange of data and movement of both
components and products. The Company recently completed the first
phase of a project to upgrade the computer hardware and software
it uses to operate, monitor and manage its business on a day to
day basis. At the end of the third quarter, the Company's
operations were converted to this system on an integrated, world-
wide basis. This effort was undertaken to significantly improve
the tools and information available to manage the Company. These
tools have the added benefit of managing data with dates beyond
December 31, 1999 as indicated by the vendors. The Company
continues to test such capabilities as part of its post-
implementation process. This testing is expected to be completed
during the second quarter of 1999. The Company's current estimate
is that the costs specifically associated with this testing and
validation process will not have a material adverse effect on the
result of operations or financial position of the Company in any
given year. Despite the Company's efforts to address the year 2000
impact on its internal systems, it is impossible to know with
certainty the impact the year 2000 issue will have on the business
and what additional expenses may be incurred. See "-Information
Technology and Telecommunications Systems."
 
In addition, even if the internal systems of the Company are not
materially affected by the year 2000 issue, the Company could be
affected through disruption in the operation of the enterprises
with which the Company interacts. The Company is in the process of
identifying significant external agents such as service providers,
vendors, suppliers and customers and attempting to reasonably
determine their ability to manage year 2000 issues.
 
The total costs associated with year 2000 compliance are not
expected to be material to the company's financial position. The
most significant cost was averted by the Company's otherwise
planned ERP installation. Ongoing compliance efforts including IT
systems testing and the review of external agents will be carried
out in the normal course of business. The Company has not attempted
to isolate and specifically identify total expenses associated with
this effort. It is not possible for the Copmany to determine
with certainty the impact of the year 2000 problem due to
internal computer systems or external agents. The failure to
correct a material year 2000 problem or to anticipate and
mitigate a problem with an external agent could result in an
interruption in or failure of normal business activities or
operations. Such failures could materially and adversely affect
the company's results of operations, liquidity and financial
condition. Contingency plans will be developed if it appears the
Company or its key external agents will not be year 2000
compliant, and such compliance is expected to have a material
adverse impact on the Company's operations.
 
Capital Needs
 
There can be no assurance that additional capital beyond the
amounts currently forecasted by the Company will not be required
or that any required additional capital will be available on
reasonable terms, if at all, at such time or times as required by
the Company. 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. Any shortfall in
capital resources compared to the Company's level of operations or
any inability to secure additional capital as needed could impair
the Company's ability to finance inventory, accounts receivable
and other operational needs. Such capital limitations could also
impair the Company's ability to invest in research and
development, improve customer service and support, deploy
information technology systems, and expand manufacturing and other
operations, including investments in the Company's new business
areas. Failure to keep pace with competitive requirements in any
of these areas could have a material adverse effect on the
Company's business and operating results. Moreover, any need to
raise additional capital through the issuance of equity or debt
securities may result in additional dilution to earnings per
share.
 
Proprietary Rights
 
While the Company had 17 issued U.S. Patents and 20 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. There can be no assurance that the
Company's measures to protect its proprietary rights will deter or
prevent unauthorized use of the Company's technology, brand or
other proprietary or intellectual property. In addition, the laws
of certain foreign countries may not protect the Company's
proprietary rights to the same extent as do the laws of the United
States or the EC. As is typical in its industry, the Company from
time to time is subject to legal claims asserting that the Company
has violated the proprietary rights of third parties. In the event
that a third party was to sustain a valid claim against the
Company, and any required licenses were not available on
commercially reasonable terms, the Company's operating results
could be materially and adversely affected. Litigation, which
could result in substantial cost and diversion of the resources of
the Company, may also be necessary to enforce proprietary rights
of the Company or to defend the Company against claimed
infringement of the proprietary rights of others.
 
Stock Price Volatility
 
The trading price of the Company's Common Stock has been subject
to significant fluctuations to date, and could be subject to wide
fluctuations in the future in response to quarter-to-quarter
variations in operating results, announcements of technological
innovations, new products or significant OEM systems design wins
by the Company or its competitors, general conditions in the
markets for the Company's products or the computer industry, the
price and availability of purchased components, general financial
market conditions, market conditions for PC or semiconductor
stocks, changes in earnings estimates by analysts, or other events
or factors. In this regard, the Company does not endorse and
accepts no responsibility for the estimates or recommendations
issued by stock research analysts from time to time. In addition,
the public stock markets in general, and technology stocks in
particular, have experienced extreme price and trading volume
volatility. This volatility has significantly affected the market
prices of securities of many high technology companies for reasons
frequently unrelated to the operating performance of the specific
companies. These broad market fluctuations may adversely affect
the market price of the Company's Common Stock.
 
Dependence on Key Personnel
 
The Company's future success will depend to a significant extent
upon the efforts and abilities of its senior management and
professional, technical, sales and marketing personnel. The
competition for such personnel is intense, particularly in the San
Jose, California area ("Silicon Valley"). There can be no
assurance that the Company will be successful in retaining its
existing key personnel or in attracting and retaining the
additional key personnel that it requires. The loss of services of
one or more of its key personnel or the inability to add or
replace key personnel could have a material adverse effect on the
Company. The salary, performance bonus and stock option packages
necessary to recruit or retain key personnel, particularly in
Silicon Valley, may significantly increase the Company's expense
levels or result in dilution to the Company's earnings per share.
The Company does not carry "key person" life insurance on any of
its employees.
 
Legal Matters
 
The Company has been named as a defendant in several putative
class action lawsuits which were filed in June and July, 1996 and
June, 1997 in the California Superior Court for Santa Clara County
and the U.S. District Court for the Northern District of
California. Certain executive officers and directors of the
Company are also named as defendants. The plaintiffs purport to
represent a class of all persons who purchased the Company's
Common Stock between October 18, 1995 and June 20, 1996 (the
"Class Period"). The complaints allege claims under the federal
securities law and California law. The plaintiffs allege that the
Company and the other defendants made various material
misrepresentations and omissions during the Class Period. The
complaints do not specify the amount of damages sought. The
Company believes that it has good defenses to the claims alleged
in the lawsuits and will defend itself vigorously against these
actions. No trial date has been set for any of these actions. The
ultimate outcome of these actions cannot be presently determined.
Accordingly, no provision for any liability or loss that may
result from adjudication or settlement thereof has been made in
the accompanying consolidated financial statements.
 
The Company has been named as a defendant in a lawsuit filed on
October 9, 1998 in the United States District Court for the
Central District of California. Plaintiffs are the Recording
Industry Association of America, Inc. (the "RIAA"), a trade
organization representing recording companies and the Alliance of
Artists and Recording Companies (the "AARC") an organization
controlled by the RIAA which exists to distribute royalties
collected by the copyright office. The complaint alleges that the
Company's Rio product, a portable music player, is subject to
regulation under the Audio Home Recording Act (the "AHRA") and
that the device does not comply with the requirements of the AHRA.
On October 16, 1998 a hearing was held and the Court issued a
Temporary Restraining Order preventing the Company from
manufacturing or distributing the Rio product for a period of ten
days. On October 26, 1998 a hearing was held to determine if a
Preliminary Injunction should be issued to further restrain the
Company until the conclusion of the suit. The court denied the
motion and refused to restrain the Company from manufacturing and
distributing the Rio product. The RIAA has appealed the Court's
ruling to the United States Court of Appeals for the Ninth
Circuit. Briefing has been conducted and on April 15, 1999 oral
argument was heard regarding the appeal. On November 30, 1998 the
Company filed an answer to the complaint together with
counterclaims alleging various antitrust, unfair competition and
other claims for  damages as well as counterclaims seeking a
declaration the AHRA is unconstitutional. On April 26, 1999 a
hearing on a motion to dismiss certain counterclaims was held. The
Court granted the motion with respect to product defamation, trade
libel and interference with prospective economic advantage. The
Court is allowing the Company to replead these claims. No firm
trial schedule has been established. No provision for any
liability or loss that may result from adjudication or settlement
of this action has been made in the accompanying consolidated
financial statements.
 
The Company is also party to other claims and pending legal
proceedings that generally involve employment and trademark
issues. These cases are, in the opinion of management, ordinary
and routine matters incidental to the normal business conducted by
the Company. In the opinion of management, the ultimate
disposition of such proceedings will not have a materially adverse
effect on the Company's consolidated financial position or future
results of operations.
 
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT 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.
 
 
 
PART II - OTHER INFORMATION
 
ITEM 1. LEGAL PROCEEDINGS
 
The Company has been named as a defendant in several putative
class action lawsuits which were filed in June and July, 1996 and
June, 1997 in the California Superior Court for Santa Clara County
and the U.S. District Court for the Northern District of
California. Certain executive officers and directors of the
Company are also named as defendants. The plaintiffs purport to
represent a class of all persons who purchased the Company's
Common Stock between October 18, 1995 and June 20, 1996 (the
"Class Period"). The complaints allege claims under the federal
securities law and California law. The plaintiffs allege that the
Company and the other defendants made various material
misrepresentations and omissions during the Class Period. The
complaints do not specify the amount of damages sought. The
Company believes that it has good defenses to the claims alleged
in the lawsuits and will defend itself vigorously against these
actions. No trial date has been set for any of these actions. The
ultimate outcome of these actions cannot be presently determined.
Accordingly, no provision for any liability or loss that may
result from adjudication or settlement thereof has been made in
the accompanying consolidated financial statements.
 
The Company has been named as a defendant in a lawsuit filed on
October 9, 1998 in the United States District Court for the
Central District of California. Plaintiffs are the Recording
Industry Association of America, Inc. (the "RIAA"), a trade
organization representing recording companies and the Alliance of
Artists and Recording Companies (the "AARC") an organization
controlled by the RIAA which exists to distribute royalties
collected by the copyright office. The complaint alleges that the
Company's Rio product, a portable music player, is subject to
regulation under the Audio Home Recording Act (the "AHRA") and
that the device does not comply with the requirements of the AHRA.
On October 16, 1998 a hearing was held and the Court issued a
Temporary Restraining Order preventing the Company from
manufacturing or distributing the Rio product for a period of ten
days. On October 26, 1998 a hearing was held to determine if a
Preliminary Injunction should be issued to further restrain the
Company until the conclusion of the suit. The court denied the
motion and refused to restrain the Company from manufacturing and
distributing the Rio product. The RIAA has appealed the Court's
ruling to the United States Court of Appeals for the Ninth
Circuit. Briefing has been conducted and on April 15, 1999 oral
argument was heard regarding the appeal. On November 30, 1998 the
Company filed an answer to the complaint together with
counterclaims alleging various antitrust, unfair competition and
other claims for  damages as well as counterclaims seeking a
declaration the AHRA is unconstitutional. On April 26, 1999 a
hearing on a motion to dismiss certain counterclaims was held. The
Court granted the motion with respect to product defamation, trade
libel and interference with prospective economic advantage. The
Court is allowing the Company to replead these claims. No firm
trial schedule has been established. No provision for any
liability or loss that may result from adjudication or settlement
of this action has been made in the accompanying consolidated
financial statements.
 
The Company is also party to other claims and pending legal
proceedings that generally involve employment and trademark
issues. These cases are, in the opinion of management, ordinary
and routine matters incidental to the normal business conducted by
the Company. In the opinion of management, the ultimate
disposition of such proceedings will not have a materially adverse
effect on the Company's consolidated financial position or future
results of operations.
 
 
ITEM 2. CHANGES IN SECURITIES
 
Not applicable.
 
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
 
Not applicable.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
None
 
ITEM 5. OTHER INFORMATION
 
        Pursuant to Rule 14a-4(c)(1) under the Securities and
Exchange Act of 1934, the proxies of management would be allowed
to use their discretionary voting authority with respect to any
non-Rule 14a-8 stockholder proposal raised at the Company's annual
meeting of stockholders, without any discussion of the matter in
the proxy statement, unless the stockholder has notified the
Company of such proposal at least 45 days prior to the month and
day on which the Company mailed its prior year's proxy statement.
Since the Company mailed its proxy statement for the 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, 1999.
 
ITEM 6.         EXHIBITS AND REPORTS ON FORM 8-K
 
A.      Exhibit
 
Exhibit #       Description of Document
 
10.1            Line of Credit Agreement between the Registrant and
                FINOVA Capital dated January 21, 1999.
 
27.1            Financial Data Schedule
 
 
B.      Reports on Form 8-K
 
None
 
 
 
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:   May 12, 1999            /s/  William J. Schroeder
                                William J. Schroeder
                                President and Chief Executive Officer
 
 
Date:   May 12, 1999            /s/  James M. Walker
                                James M. Walker
                                Senior Vice President and Chief Financial
                                Officer
 
 
 
 
 
 
 
 
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