<PAGE>   1
                UNITED STATES SECURITIES AND 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 quarter ended June 30, 1999 OR

[ ]     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
        EXCHANGE ACT OF 1934

For the transition period from __________ to __________

                         Commission file number 0-21126

                                 S3 INCORPORATED
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

               DELAWARE                                  77-0204341
      (State or other jurisdiction          (I.R.S. Employer Identification No.)
   of incorporation or organization)

     2841 Mission College Boulevard
        Santa Clara, California                          95054-1838
(Address of principal executive offices)                 (Zip Code)

       Registrant's telephone number, including area code: (408) 588-8000

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 [X]

               The number of shares of the Registrant's Common Stock, $.0001 par
value, outstanding at August 10, 1999 was 53,593,677.



<PAGE>   2

                                 S3 INCORPORATED
                                    FORM 10-Q


                                      INDEX

                                                                        PAGE
                                                                        ----
<TABLE>
<CAPTION>
<S>                                                                <C>
PART I.    CONDENSED CONSOLIDATED FINANCIAL INFORMATION

Item 1.    Condensed Consolidated Financial Statements:

           Condensed Consolidated Balance Sheets
           June 30, 1999 and December 31, 1998                                 3

           Condensed Consolidated Statements of Operations
           Three months ended and six months ended
           June 30, 1999 and 1998                                              4

           Condensed Consolidated Statements of Cash Flows
            Six months ended June 30, 1999 and 1998                            5

           Notes to Unaudited Condensed Consolidated Financial Statements    6-9

Item 2.    Management's Discussion and Analysis of
           Financial Condition and Results of Operations                   10-24

Item 3.    Quantitative and Qualitative Disclosures About Market Risk     24 -25

PART II.   OTHER INFORMATION

Item 1.    Legal Proceedings                                                  25

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             25-26

Item 5.    Other Information                                        Not Applicable

Item 6.    Exhibits and Reports on Form 8-K                                   26

Signatures                                                                    27
</TABLE>


                                       2
<PAGE>   3




PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

                                 S3 INCORPORATED
                      CONDENSED CONSOLIDATED BALANCE SHEETS
                 (In thousands, except share and per share data)

<TABLE>
<CAPTION>

                                                     June 30,   December 31,
                                                       1999         1998
                                                    ----------  ------------
                                                    (Unaudited)
                                ASSETS
<S>                                                <C>            <C>
Current assets:
   Cash and cash equivalents                       $  36,628      $  31,022
   Short-term investments                             94,795         88,553
   Accounts receivable (net of allowances
     of $6,425 in 1999 and $6,525 in 1998)            35,845         23,864
   Inventories                                        17,440         11,383
   Prepaid taxes                                         139         20,203
   Prepaid expenses and other                         17,549         22,153
                                                   ---------      ---------
               Total current assets                  202,396        197,178

Property and equipment,  net                          17,315         22,392
Investment in joint venture                           91,056         88,056
Other assets                                          28,324         18,175
                                                   ---------      ---------
               Total                               $ 339,091      $ 325,801
                                                   =========      =========

                      LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
   Accounts payable                                $  40,469      $  16,315
   Notes payable                                       9,600         14,400
   Accrued liabilities                                12,211         12,314
   Deferred revenue                                      703          1,905
                                                   ---------      ---------
               Total current liabilities              62,983         44,934

Notes payable                                          4,800             --
Other liabilities                                     13,021         13,837
Convertible subordinated notes                       103,500        103,500


Stockholders' equity:
   Common stock, $.0001 par value;
    120,000,000 and 70,000,000 shares
    authorized in 1999 and 1998, respectively;
    52,978,415 and 51,716,171 shares
    outstanding in 1999 and 1998, respectively       197,744        191,647
   Accumulated other comprehensive loss              (16,816)       (14,755)
   Accumulated deficit                               (26,141)       (13,362)
                                                   ---------      ---------
               Total stockholders' equity            154,787        163,530
                                                   =========      =========
               Total                               $ 339,091      $ 325,801
                                                   =========      =========

</TABLE>

                See accompanying notes to the unaudited condensed
                       consolidated financial statements.


                                       3
<PAGE>   4
                                 S3 INCORPORATED
                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                    (In thousands, except per share amounts)
                                   (Unaudited)

<TABLE>
<CAPTION>

                                                              Three Months Ended                   Six Months Ended
                                                     ---------------------------------     --------------------------------
                                                     June 30, 1999       June 30, 1998     June 30, 1999      June 30, 1998
                                                     -------------       -------------     -------------      -------------
<S>                                                  <C>                <C>                <C>                <C>
Net sales                                              $  57,253          $  53,299          $ 101,553          $ 135,806

Cost of sales                                             40,716             46,807             74,749            113,636
                                                       ---------          ---------          ---------          ---------

Gross margin                                              16,537              6,492             26,804             22,170

Operating expenses:
    Research and development                              17,450             18,334             35,487             40,367
    Selling, marketing and administrative                  8,543             10,643             16,331             23,137
    Other operating expense                                   --                 --                 --              8,000
                                                       ---------          ---------          ---------          ---------
               Total operating expenses                   25,993             28,977             51,818             71,504
                                                       ---------          ---------          ---------          ---------
Loss from operations                                      (9,456)           (22,485)           (25,014)           (49,334)
Gain on sale of shares of joint venture                    7,207                 --              7,207             26,561
Other income (expense), net                                  283             (4,193)               440             (4,185)
                                                       ---------          ---------          ---------          ---------

Loss before income taxes and equity
     in income of joint venture                           (1,966)           (26,678)           (17,367)           (26,958)
Benefit for income taxes                                      --            (11,205)                --            (11,956)
                                                       ---------          ---------          ---------          ---------
Loss before equity in income of joint venture             (1,966)           (15,473)           (17,367)           (15,002)
Equity in income of joint venture (net of tax)             3,066              3,839              4,588              7,489
                                                       ---------          ---------          ---------          ---------
Net income (loss)                                      $   1,100          $ (11,634)         $ (12,779)         $  (7,513)
                                                       =========          =========          =========          =========

Per share amounts:
    Basic                                              $    0.02          $   (0.23)         $   (0.24)         $   (0.15)
    Diluted                                            $    0.02          $   (0.23)         $   (0.24)         $   (0.15)

Shares used in computing per share amounts:
    Basic                                                 53,164             50,985             52,510             50,793
    Diluted                                               57,588             50,985             52,510             50,793
</TABLE>

                See accompanying notes to the unaudited condensed
                       consolidated financial statements.


                                       4
<PAGE>   5
                                S3 INCORPORATED
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (In thousands)
                                  (Unaudited)
<TABLE>
<CAPTION>

                                                                      SIX MONTHS ENDED
                                                             -----------------------------------
                                                              JUNE 30, 1999        JUNE 30, 1998
                                                             ---------------    ----------------

<S>                                                          <C>               <C>
Operating activities:
  Net loss                                                     $(12,779)         $ (7,513)
  Adjustments to reconcile net loss to net
    cash provided by (used for) operating activities:
    Deferred income taxes                                            81             5,469
    Depreciation and amortization                                 9,067            11,142
    Write-off of acquired technologies                               --             8,000
    Gain on sale of shares of joint venture                      (7,207)          (26,561)
    Equity in income of joint venture                            (4,588)          (12,202)
  Changes in assets and liabilities:
            Accounts receivable                                 (11,981)           38,525
            Inventories                                          (6,057)           24,603
            Prepaid taxes / Income taxes payable                 20,064            (5,756)
            Prepaid expenses and other                            4,605             1,892
            Accounts payable                                     24,154           (12,267)
            Accrued liabilities                                  (1,000)           (1,548)
            Deferred revenue                                     (1,202)           (9,849)
                                                               --------          --------
  Net cash provided by operating activities                      13,157            13,935
                                                               --------          --------

Investing activities:
  Property and equipment purchases, net                          (2,736)           (1,579)
  Sale of shares of joint venture                                 7,207            68,025
  Purchase of short-term investments, net                        (6,725)          (60,401)
  Issuance of notes receivable                                  (10,000)               --
  Other assets                                                   (1,394)            1,968
  Purchase of technology                                             --           (40,000)
                                                               --------          --------
  Net cash used for investing activities                        (13,648)          (31,987)
                                                               --------          --------

Financing activities:
  Sale of common stock, net                                       5,107             2,929
  Sale of warrant                                                   990                --
  Repayments of equipment financing                                  --            (2,913)
  Repayments of notes payable                                        --           (10,000)
                                                               --------          --------
  Net cash provided by (used for) financing activities            6,097            (9,984)
                                                               --------          --------

Net increase (decrease) in cash and equivalents                   5,606           (28,036)
Cash and cash equivalents at beginning of period                 31,022            90,484
                                                               --------          --------
Cash and cash equivalents at end of period                     $ 36,628          $ 62,448
                                                               ========          ========

</TABLE>



               See accompanying notes to the unaudited condensed
                       consolidated financial statements.

                                       5
<PAGE>   6

                                 S3 INCORPORATED
         NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1. Basis of Presentation:

        The condensed consolidated financial statements have been prepared by S3
Incorporated, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission and include the accounts of S3 Incorporated
and its wholly-owned subsidiaries ("S3" or collectively the "Company"). All
significant inter-company balances and transactions have been eliminated.
Investments in entities in which the Company does not have control, but has the
ability to exercise significant influence over operating and financial policies
are accounted for by the equity method. Certain information and footnote
disclosures, normally included in financial statements prepared in accordance
with generally accepted accounting principles, have been condensed or omitted
pursuant to such rules and regulations. In the opinion of the Company, the
financial statements reflect all adjustments, consisting only of normal
recurring adjustments, necessary for a fair presentation of the financial
position at June 30, 1999 and December 31, 1998, and the operating results and
cash flows for the six months ended June 30, 1999 and 1998. These financial
statements and notes should be read in conjunction with the Company's audited
financial statements and notes thereto for the year ended December 31, 1998,
included in the Company's Form 10-K filed with the Securities and Exchange
Commission.

        The results of operations for the three and six months ended June 30,
1999 are not necessarily indicative of the results that may be expected for the
future quarters or the year ending December 31, 1999. Certain reclassifications
of 1998 amounts were made in order to conform to the 1999 presentation.

2. Inventories:

        Inventories consist of work in process and finished goods and are stated
at the lower of cost (first-in, first-out) or market.
<TABLE>
<CAPTION>

                                JUNE 30,       DECEMBER 31,
                                  1999           1998
                                -------        ----------
                                     (IN THOUSANDS)
<S>                            <C>             <C>
Inventories consist of:
Work in process                 $ 7,123         $ 6,340
Finished goods                   10,317           5,043
                                -------         -------
   Total                        $17,440         $11,383
                                =======         =======
</TABLE>

3. Other Operating Expenses:

        In January 1998, the Company entered into a $40.0 million technology
exchange with Cirrus Logic, Inc. to obtain graphic functionality technologies.
As a result of the exchange, the Company acquired the technology covered by 10
graphic patents and 25 graphic patent applications, as well as cross-licensed
Cirrus Logic's remaining patents. Under the terms of the cross-licensing
provisions, the Company and Cirrus Logic have a perpetual license to each
other's graphic patents and additional licenses with respect to the other
party's patents for agreed upon periods of time.

        The Company wrote-off $8.0 million of the acquired technologies in the
first quarter of 1998 that were not realizable based on estimated cash flows
from the sale of products currently sold by the Company. The remaining $32.0
million intangible asset was being amortized to cost of sales based on the
estimated lives of the currently utilized core technologies, which was generally
five years until the fourth quarter of 1998. During the fourth quarter of 1998,
management reevaluated the carrying value of the intangible assets recorded in
connection with the technology exchange with Cirrus Logic, Inc. and related to
the patents obtained from Brooktree, as well as other long-lived assets,
including property and equipment. This revaluation was necessitated by
management determination based on recent results of operations and that the
future expected sales and cash flows for the Company's operations would be
substantially lower than had been previously expected by management. Expected
undiscounted future cash flows were not sufficient to recover the carrying value
of such assets. Accordingly, an impairment loss of $27.2 million was recognized
for write-downs of a substantial portion of the intangible assets in the fourth
quarter of 1998. The estimated fair value of the intangible assets was based on
management's best estimate of the patent portfolio based on a comparison to
other graphics technology portfolios in the marketplace. Due to technological
changes in the graphics marketplace, the Company concluded it should accelerate
its amortization

                                       6

<PAGE>   7

of its remaining patent portfolio, of approximately $4.0 million, over the
current estimated life of the currently utilized core technologies, which is two
years.

        In July 1998, the Company implemented a restructuring plan in order to
align resources with a new business model and to lower the Company's overall
cost structure. In connection with the restructuring, the Company reduced its
headcount and consolidated facilities. As of June 30, 1999, all severance
packages have been paid and there is no remaining balance in the restructuring
reserve.

4. Earnings (Loss) Per Share:

        Basic earnings (loss) per share (EPS) is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted EPS reflects the potential dilution that
would occur from any instrument or options which could result in additional
common shares being issued.

        When computing earnings (loss) per share, the Company includes only
potential common shares that are dilutive. Exercise of options, and conversion
of convertible debt in the six months ended June 30, 1999 and in the three and
six months ended June 30, 1998 are not assumed because the result would have
been anti-dilutive. The warrant exercise during the six months ended June 30,
1999 is not assumed because the result would have been anti-dilutive.

        The following table sets forth the computation of basic and diluted
earnings (loss) per share:
<TABLE>
<CAPTION>

                                                                   THREE MONTHS ENDED                 SIX MONTHS ENDED
                                                           -------------------------------     -------------------------------
                                                           JUNE 30, 1999     JUNE 30, 1998     JUNE 30, 1999     JUNE 30, 1998
                                                           -------------     -------------     -------------     -------------
                                                                            (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                                        <C>               <C>               <C>               <C>

                  NUMERATOR
   Net income (loss)
      Basic                                                   $  1,100         $(11,634)         $(12,779)         $ (7,513)
                                                              --------         --------          --------          --------
      Diluted                                                 $  1,100         $(11,634)         $(12,779)         $ (7,513)
                                                              ========         ========          ========          ========

DENOMINATOR
    Denominator for basic earnings (loss) per share             53,164           50,985            52,510            50,793
    Common stock equivalents                                     4,424               --                --                --
                                                              --------         --------          --------          --------
    Denominator for diluted earnings (loss) per share           57,588           50,985            52,510            50,793
                                                              ========         ========          ========          ========
Basic earnings (loss) per share                               $   0.02         $  (0.23)         $  (0.24)         $  (0.15)
Diluted earnings (loss) per share                             $   0.02         $  (0.23)         $  (0.24)         $  (0.15)

</TABLE>

5.   Investment in USC

        During 1995, the Company entered into two long-term manufacturing
capacity arrangements. The Company entered into an agreement with United
Microelectronics Corporation (UMC) and Alliance Semiconductor Corporation to
form United Semiconductor Corporation (USC), a separate Taiwanese company, for
the purpose of building and managing a semiconductor manufacturing facility in
Taiwan, Republic of China. The Company invested a total of $89.4 million for its
equity interest of 23.75%. On December 31, 1997, the Company entered into an
agreement with UMC to sell to UMC 80 million shares of stock of USC for a
purchase price of 2.4 billion New Taiwan dollars. The Company received the
purchase price (approximately $68.0 million in cash) in January 1998 upon
closing. As a result of the January 1998 sale to UMC, S3's percentage ownership
in USC decreased to 15.75%. The Company has the right to purchase up to 31.25%
of the output from the foundry.

        In June 1999, the Company amended its agreements with UMC. Under the
terms of the amended agreements, UMC has agreed to pay the Company, subject to
certain conditions, 1.4 billion New Taiwan dollars (approximately U.S. $43.3
million at exchange rates prevailing on June 30, 1999) and the Company has
agreed to release UMC from contingencies associated with the sale of 80 million
shares of stock of USC in January 1998 and to grant a license to patents
covering multimedia products and integrated circuit manufacturing technology for
use in products manufactured by UMC. Payments will be received over five fiscal
quarters beginning in the quarter ended June 30, 1999. The Company agreed to
waive rights to its USC board seat and determined that it no longer could
exercise significant influence over the financial and operating decisions of
USC. Accordingly, in June 1999 the Company ceased accounting for its investment
in USC using the equity method of accounting.


                                       7

<PAGE>   8

        In June 1999, UMC announced plans to consolidate into UMC three foundry
joint ventures, including USC, and one foundry company that is publicly traded
in Taiwan. If this consolidation is effected as planned by UMC before the end
of December 1999, the Company would receive one UMC share for each of the 252
million USC shares it owns. UMC has informed the Company that it expects the
UMC shares to be received by the Company in the consolidation will be eligible
for trading on the Taiwan Stock Exchange. Completion of this transaction is
subject to regulatory and other approvals.

6. Wafer supply agreements and commitments

        In 1995 the Company expanded and formalized its relationship with Taiwan
Semiconductor Manufacturing Company (TSMC) to provide additional capacity over
the 1996 to 2000 timeframe. The agreement with TSMC requires the Company to make
certain annual advance payments to be applied against the following year's
capacity. The Company has signed promissory notes to secure these payments over
the term of the agreement. At June 30, 1999, the remaining advance payments (and
corresponding promissory notes) totaled $14.4 million. During the second quarter
of 1999, the Company and TSMC agreed to extend the capacity term of the
agreement by two years to 2002. The corresponding notes payable were extended
with the final payment due in 2001.

        In the ordinary course of business, the Company places purchase orders
with its wafer suppliers based on its existing and anticipated customer orders
for its products. Should the Company experience a substantial unanticipated
decline in the selling price of its products and/or demand thereof, it could
result in a material loss on such purchase commitments.

7. Contingencies

        The semiconductor industry is characterized by frequent litigation
regarding patent and other intellectual property rights. The Company is party to
various claims of this nature. Although the ultimate outcome of these matters is
not presently determinable, management believes that the resolution of all such
pending matters will not have a material adverse effect on the Company's
financial position or results of operations.

        Since November 1997, a number of complaints have been filed in federal
and state courts seeking an unspecified amount of damages on behalf of an
alleged class of persons who purchased shares of the Company's common stock at
various times between April 18, 1996 and November 3, 1997. The complaints name
as defendants the Company, certain of its officers and former officers, and
certain directors of the Company, asserting that they violated federal and state
securities laws by misrepresenting and failing to disclose certain information
about the Company's business. In addition, certain stockholders have filed
derivative actions in the state courts of California and Delaware seeking
recovery on behalf of the Company, alleging, among other things, breach of
fiduciary duties by such individual defendants. The derivative cases in
California state court have been consolidated, and plaintiffs have filed a
consolidated amended complaint. The court has entered a stipulated order in
those derivative cases suspending court proceedings and coordinating discovery
in them with discovery in the class actions in California state courts. On
plaintiffs' motion, the federal court has dismissed the federal class actions
without prejudice. The class actions in California state court have been
consolidated, and plaintiffs have filed a consolidated amended complaint. The
Company has answered that complaint. Discovery is pending. While management
intends to defend the actions against the Company vigorously, there can be no
assurance that an adverse result or settlement with regards to these lawsuits
would not have a material adverse effect on the Company's financial condition or
results of operations.

        The Company has received from the United States Securities and Exchange
Commission a request for information relating to the Company's restatement
announcement in November 1997. The Company has responded and intends to continue
to respond to such requests.

8. Comprehensive Income

        Under SFAS No. 130, "Reporting Comprehensive Income" ("SFAS 130")
unrealized gains or losses on the Company's available-for-sale securities and
foreign currency translation adjustments are to be included in other
comprehensive loss. Prior year financial statements have been reclassified to
conform to the requirements of SFAS 130.


                                       8

<PAGE>   9
        The following are the components of accumulated other comprehensive
loss, net of tax:
<TABLE>
<CAPTION>

                                                 JUNE 30,          DECEMBER 31,
                                                   1999               1998
                                               -------------       ----------
                                                         (IN THOUSANDS)

<S>                                             <C>               <C>
Unrealized loss on investments                   $ (2,812)         $ (2,329)
Foreign currency translation adjustments          (14,004)          (12,426)
                                                 --------          --------
Accumulated other comprehensive loss             $(16,816)         $(14,755)
                                                 ========          ========
</TABLE>


        The following schedule of other comprehensive income (loss) shows the
gross current-period gain and the reclassification adjustment:
<TABLE>
<CAPTION>

                                                                   THREE MONTHS ENDED                 SIX MONTHS ENDED
                                                           -------------------------------     -------------------------------
                                                           JUNE 30, 1999     JUNE 30, 1998     JUNE 30, 1999     JUNE 30, 1998
                                                           -------------     -------------     -------------     -------------
                                                                                      (IN THOUSANDS)
<S>                                                        <C>               <C>               <C>               <C>

Unrealized gain on investments:
  Unrealized loss on available-for-sale securities           $  (929)           $(2,501)           $  (550)           $(2,418)
  Less: reclassification adjustment for (gain)
     loss realized in net income                                  21                  1                 67                (32)
                                                             -------            -------            -------            -------
Net unrealized loss on investments                              (908)            (2,500)              (483)            (2,450)
Foreign currency translation adjustments                       1,126             (3,801)            (1,578)             1,799
                                                             -------            -------            -------            -------
Other comprehensive income (loss)                            $   218            $(6,301)           $(2,061)           $  (651)
                                                             =======            =======            =======            =======
</TABLE>

9. Acquisition of Diamond Multimedia Systems, Inc.

        On June 25, 1999, the Company entered into an Agreement and Plan of
Merger with Diamond Multimedia Systems, Inc. ("Diamond") whereby a wholly-owned
subsidiary of the Company will be merged with and into Diamond, with Diamond as
the surviving entity (the "Merger"). As a result of the Merger, the outstanding
shares of common stock of Diamond will be converted into shares of common stock
of the Company at an exchange ratio equal to 0.52 share of S3 common stock for
each share of Diamond common stock. Upon completion of the Merger, Diamond will
become a wholly-owned subsidiary of the Company. The closing of the Merger is
subject to certain conditions, including the approval of the stockholders of
Diamond and the Company and the expiration or early termination of the
applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements
Act.

        The Company and Diamond entered into a Credit Agreement, dated as of
June 10, 1999, and amended on June 14, 1999 (the "Credit Agreement"), pursuant
to which the Company agreed to make three separate loans to Diamond in amounts
not exceeding $20.0 million in the aggregate. The loans are subordinated to
Diamond's existing indebtedness with Finova Capital Corporation, with whom
Diamond has a $50.0 million revolving credit line, and to the guarantee to Sanwa
Bank, Ltd. of obligations in the approximate amount of $2.9 million. The loans
accrue interest at the "prime rate" as published in the "Money Rates" section of
the Wall Street Journal and interest will be payable in arrears on the last day
of each month. The principal balance of the loans is scheduled to be repaid by
June 10, 2000. However, Diamond may prepay any portion of the loans any time
without penalty or premium. As of June 30, 1999, the Company had made loans to
Diamond in the aggregate amount of $10.0 million. In July 1999, the Company made
loans to Diamond in the aggregate amount of $10.0 million.

        One of the conditions precedent to the making of each of the three loans
to Diamond under the Credit Agreement is that Diamond shall have issued common
stock purchase warrants to the Company. Diamond issued to the Company three
warrants to purchase an aggregate of 4,597,871 shares of Diamond common stock at
exercise prices ranging from $4.18 to $4.471875 per share.

        The Company intends to account for its acquisition of Diamond using the
purchase method of accounting.

        Because of Diamond's liquidity position and resulting cash constraints,
which resulted from its working capital requirements and continued investments
in new product lines such as the Rio Internet audio player and HomeFree line of
home networking products, in July 1999, Diamond assigned its rights to acquire
OneStep, LLC, to S3 and S3 acquired OneStep for approximately $10.0 million in
cash. OneStep is a software development company that supplies the Rio Audio
Manager for Diamond's Rio Internet audio players. Under its agreements with S3,
Diamond is currently funding the operating expenses of OneStep and S3 has
licensed to Diamond's wholly owned subsidiary, RioPort.com, Inc., OneStep's
intellectual property, Diamond currently intends to carve out RioPort as an
independently managed company funded by outside investors, while maintaining a
substantial equity position in RioPort. At the same time as RioPort's planned
venture capital financing, S3 intends to sell OneStep to RioPort in exchange for
cash and shares of RioPort stock.



                                       9

<PAGE>   10
PART I. CONDENSED CONSOLIDATED FINANCIAL INFORMATION

Item 2. Management's Discussion and Analysis of Financial Condition and Results
        of Operations

     When used in this Report, the words "expects", "anticipates", "estimates"
and similar expressions are intended to identify forward-looking statements.
Such statements, which include statements concerning the timing of availability
and functionality of products under development, trends in the personal computer
("PC") market, the percentage of export sales and sales to strategic customers,
and the adoption or retention of industry standards, and the availability and
cost of products from the Company's suppliers, are subject to risks and
uncertainties, including those set forth under "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Factors That May
Affect Our Results" and elsewhere in this report, that could cause actual
results to differ materially from those projected. These forward-looking
statements speak only as of the date hereof. The Company expressly disclaims any
obligation or undertaking to release publicly any updates or revisions to any
forward-looking statements contained herein to reflect any change in the
Company's expectations with regard thereto or any change in events, conditions
or circumstances on which any such statement is based.

OVERVIEW

     S3 Incorporated ("S3" or the "Company") is a leading supplier of
multimedia acceleration hardware and its associated software for the PC market.
The Company's accelerators are designed to work cooperatively with a PC's
central processing unit ("CPU"), implementing functions best suited for a
dedicated accelerator while allowing the CPU to perform the more general purpose
computing functions of today's advanced multimedia user interface and
applications. By complementing the computing power of the general purpose CPU,
the Company's integrated software and silicon-based accelerator solutions
significantly improve the multimedia performance of PCs while reducing overall
system cost and complexity. S3 has been a pioneer in graphics acceleration since
1991, when it was the first company to ship in volume a single chip graphics
accelerator with a local bus interface. S3 has since delivered new generations
of high performance accelerator solutions from the first 32-bit and 64-bit
graphics accelerator families to the first 128-bit, full-featured integrated
two-dimensional ("2D") and three-dimensional ("3D") graphics and video
accelerator specifically designed for today's 3D and digital versatile disc
("DVD")-based applications. As the demand for greater multimedia capabilities in
PCs increases, particularly the demand for 2D/3D technology, the Company is
focused on delivering accelerator solutions for use in business desktop, home
and mobile computing systems. S3's families of accelerator products and software
are currently used by many of the world's leading original equipment PC
manufacturers ("OEMs") and add-in card and motherboard manufacturers.

    On June 25, 1999, the Company entered into an Agreement and Plan of Merger
with Diamond Multimedia Systems, Inc. ("Diamond") whereby a wholly-owned
subsidiary of the Company will be merged with and into Diamond, with Diamond as
the surviving entity (the "Merger"). As a result of the Merger, the outstanding
shares of common stock of Diamond will be converted into shares of common stock
of the Company at an exchange ratio equal to 0.52 share of S3 common stock for
each share of Diamond common stock. Upon completion of the Merger, Diamond will
become a wholly-owned subsidiary of the Company. The closing of the Merger is
subject to certain conditions, including the approval of the stockholders of
Diamond and the Company and the expiration or early termination of the
applicable waiting period under the Hart-Scott-Rodino Antitrust Improvement
Act. See Note 9 of Notes to Unaudited Condensed Consolidated Financial
Statements.

RESULTS OF OPERATIONS

The following table sets forth for the periods indicated certain financial data
as a percentage of net sales:

<TABLE>
<CAPTION>

                                                          THREE MONTHS ENDED                     SIX MONTHS ENDED
                                                      ---------------------------           ---------------------------
                                                      JUNE 30,           JUNE 30,           JUNE 30,          JUNE 30,
                                                        1999               1998               1999               1998
                                                      --------           --------           --------           --------
<S>                                                   <C>                <C>                <C>                <C>
Net sales                                                100.0%             100.0%             100.0%             100.0%
Cost of sales                                             71.1               87.8               73.6               83.7
                                                      --------           --------           --------           --------

Gross margin                                              28.9               12.2               26.4               16.3
Operating expenses:
   Research and development                               30.5               34.4               34.9               29.7
   Selling, marketing and administrative                  14.9               20.0               16.1               17.0
   Other operating expense                                  --                 --                 --                5.9
                                                      --------           --------           --------           --------
           Total operating expenses                       45.4               54.4               51.0               52.6
                                                      --------           --------           --------           --------
Loss from operations                                     (16.5)             (42.2)             (24.6)             (36.3)
Gain on sale of shares of joint venture                   12.6                 --                7.1               19.6
Other income (expense), net                                0.5               (7.8)               0.4               (3.1)
                                                      --------           --------           --------           --------

Loss before income taxes and equity
      in net income of joint venture                      (3.4)             (50.0)             (17.1)             (19.8)
Benefit for income taxes                                    --              (21.0)                --               (8.8)
                                                      --------           --------           --------           --------
Loss before equity in net income of joint venture         (3.4)             (29.0)             (17.1)             (11.0)
Equity in net income of joint venture (net of tax)         5.3                7.2                4.5                5.5
                                                      --------           --------           --------           --------
Net income (loss)                                          1.9%             (21.8)%            (12.6)%             (5.5)%
                                                      ========           ========           ========           ========
</TABLE>


                                       10

<PAGE>   11

NET SALES

     The Company's net sales to date have been generated from the sale of its
graphics and multimedia accelerators. The Company's products are used in, and
its business is dependent upon, the personal computer industry with sales
primarily in the U.S., Asia and Europe. Net sales were $57.3 million for the
three months ended June 30, 1999, an 7.5% increase from the $53.3 million of net
sales for the three months ended June 30, 1998. Net sales were $101.6 million
for the six months ended June 30, 1999, a 25.2% decrease from the $135.8 million
of net sales for the six months ended June 30, 1998. Net sales for the three
months and six months ended June 30, 1999 consisted primarily of the Company's
3D and Mobile products while net sales for the three months and six months ended
June 30, 1998 consisted primarily of the Company's 2D and 3D products. The
Company commenced volume shipments of its Savage4 product during the quarter
ended June 30,1999. Net sales for the three months ended June 30, 1999 increased
primarily as a result of higher unit average selling prices of Savage4 products
and the continued sale of older generation products. Net sales for the six
months ended June 30, 1999 decreased primarily as a result of a shift from sales
of 2D products to 3D products coupled with overall lower shipment volumes. Unit
volumes decreased approximately 9% and 24% for the three months and six months
ended June 30, 1999, respectively, from the three months and six months ended
June 30, 1998. The Company expects that the percentage of its net sales
represented by any one product or type of product may change significantly from
period to period as new products are introduced and existing products reach the
end of their product life cycles. Due to competitive price pressures, the
Company's products experience declining unit average selling prices over time,
which at times can be substantial.

     Prices for graphics accelerators tend to decline over time, and prices for
newly introduced products are under significant pricing pressures due in part to
aggressive pricing from some of our competitors. The Company has experienced and
anticipates that it will continue to experience increased pricing pressures on
average selling prices for the Company's ViRGE, Trio and Savage families of
accelerators.

     The graphics accelerator market has transitioned from 2D acceleration to 3D
acceleration and products that compete in the high performance segment of that
market have higher gross margins than products in the mainstream PC or in the
sub-$1,000, or "segment zero," PC market. The Company commenced shipment of its
Savage3D product during the third quarter of 1998. This product was intended to
address the high performance 3D acceleration market. However, the Savage3D
failed to achieve significant market acceptance. The Company commenced volume
shipments of its Savage4 product in the second quarter of 1999. Savage4 is
designed to compete in multiple performance segments of the commercial and
consumer PC markets of the 3D acceleration market. If the Company does not
continue to introduce and successfully market higher performance products, our
gross margin and profitability could be negatively affected.

     Export sales accounted for 82% and 93% of net sales for the three months
ended June 30, 1999 and 1998, respectively. Export sales accounted for 90% and
86% of net sales for the six months ended June 30, 1999 and 1998, respectively.
Approximately 50% and 26% of export sales for the three months ended June 30,
1999 and 1998, respectively, were to affiliates of United States customers.
Approximately 47% and 26% of export sales for the six months ended June 30, 1999
and 1998, respectively, were to affiliates of United States customers. The
Company expects that export sales will continue to represent a significant
portion of net sales, although there can be no assurance that export sales as a
percentage of net sales will remain at current levels. All sales transactions
were denominated in U.S. dollars.

    Two customers and two distributors accounted for 17%, 10%, 17% and 10% of
net sales, respectively, for the three months ended June 30, 1999. Two
distributors and one customer accounted for 43%, 11% and 10% of net sales,
respectively, for the three months ended June 30, 1998. One customer and two
distributors accounted for 25%, 21% and 12% of net sales, respectively, for the
six months ended June 30, 1999. Two distributors and one customer accounted for
37%, 12% and 11% of net sales for the six months ended June 30, 1998. The
Company expects a significant portion of its future sales to remain concentrated
within a limited number of strategic customers. There can be no assurance that
the Company will be able to retain its strategic customers or that such
customers will not otherwise cancel or reschedule orders, or in the event of
canceled orders, that such orders will be replaced by other sales. In addition,
sales to any particular customer may fluctuate significantly from quarter to
quarter. The occurrence of any such events or the loss of a strategic customer
could have a material adverse effect on the Company's operating results.

GROSS MARGIN


                                       11

<PAGE>   12
     Gross margin percentage increased to 28.9% for the three months ended June
30, 1999 from 12.2% for the three months ended June 30, 1998. Gross margin
percentage increased to 26.4% for the six months ended June 30, 1999 from 16.3%
for the six months ended June 30, 1998. The increase in gross margin for the
three and six months ended June 30, 1999 versus the three and six months ended
June 30, 1998 was the result of unanticipated sales of certain inventory
formerly reserved by the Company as well as licensing revenues associated with
29 patents licensed to UMC. The Company also took fewer inventory reserves in
the three and six months ended June 30, 1999 versus the three and six months
ended June 30, 1998 as the result of better inventory management.

     In the future, the Company's gross margin percentages may be affected by
increased competition and related decreases in the unit average selling prices
(particularly with respect to older generation products), timing of volume
shipments of new products, the availability and cost of products from the
Company's suppliers, changes in the mix of products sold, the extent to which
the Company forfeits or utilizes its production capacity rights with TSMC, the
extent to which the Company will incur additional licensing fees and shifts in
sales mix between add-in card and motherboard manufacturers and systems OEMs.

RESEARCH AND DEVELOPMENT EXPENSES

     The Company has made and intends to continue to make significant
investments in research and development to remain competitive by developing new
and enhanced products. Research and development expenses were $17.5 million for
the three months ended June 30, 1999, a decrease of $0.8 million from $18.3
million for the three months ended June 30, 1998. Research and development
expenses were $35.5 million for the six months ended June 30, 1999, a decrease
of $4.9 million from $40.4 million for the six months ended June 30, 1998. The
decrease in research and development expenses for the three months and six
months ended June 30, 1999 was primarily a result of reductions in engineering
staff which occurred as part of the Company's implementation of a restructuring
plan in July 1998. Headcount decreased by about 20% from the quarter ended June
30, 1998 to the quarter ended June 30, 1999. The Company also incurred certain
one time engineering costs during the first quarter of 1998 associated with the
discontinued audio and communications products line. The Company expects
research and development expenses to increase in absolute dollars in the third
quarter of 1999.

SELLING, MARKETING AND ADMINISTRATIVE EXPENSES

     Selling, marketing and administrative expenses were $8.5 million for the
three months ended June 30, 1999, a decrease of $2.1 million from $10.6 million
for the three months ended June 30, 1998. Selling, marketing and administrative
expenses were $16.3 million for the six months ended June 30, 1999, a decrease
of $6.8 million from $23.1 million for the six months ended June 30, 1998.
Selling, marketing and administrative expenses for the three and six months
ended June 30, 1999 decreased from the prior year primarily as a result of
headcount reductions and lower commission related payouts. Selling, marketing
and administrative headcount decreased 9% from the three months ended June 30,
1998 to the three months ended June 30, 1999. As part of the Company's July 1998
restructuring plan, the number of consultants working on various projects was
also reduced. In addition, year to date commissions were lower in the first six
months of 1999 versus 1998 as a result of the overall decrease in net sales for
the same period.

OTHER OPERATING EXPENSE

       In January 1998, the Company entered into a $40.0 million technology
exchange with Cirrus Logic, Inc. to obtain graphic functionality technologies.
As a result of the exchange, the Company acquired the technology covered by 10
graphic patents and 25 graphic patent applications, as well as cross-licensed
Cirrus Logic's remaining patents. Under the terms of the cross-licensing
provisions, the Company and Cirrus Logic have a perpetual license to each
other's graphic patents and additional licenses with respect to the other
party's patents for agreed upon periods of time. The Company wrote-off $8.0
million of the acquired technologies that were not realizable based on estimated
cash flows from the sale of products currently sold by the Company. The
remaining $32.0 million intangible asset was being amortized to cost of sales
based on the lives of the currently utilized core technologies, which was
generally five years until the fourth quarter of 1998.

       During the fourth quarter of 1998, management reevaluated the carrying
value of the intangible assets recorded in connection with the technology
exchange with Cirrus Logic, Inc., and related to the patents obtained from
Brooktree, as well as other long-lived assets, including property and equipment.
This revaluation was necessitated by management's determination based on recent
results of operations and that the future expected sales and cash flows for the
Company's operations would be substantially lower than had been

                                       12

<PAGE>   13

previously expected by management. Expected undiscounted future cash flows were
not sufficient to recover the carrying value of such assets. Accordingly, an
impairment loss of $27.2 million, representing the excess of the carrying value
over the estimated fair value of the assets, was recognized for write-downs of a
substantial portion of the intangible assets. The estimated fair value of the
intangible assets was based on management's best estimate of the patent
portfolio based on a comparison to other graphics technology portfolios in the
marketplace. The Company determined that no write-down of property and equipment
was necessary at December 31, 1998 based on its estimate of the fair value of
such assets. Due to technological changes in the graphics marketplace, the
Company concluded it should accelerate its amortization of its remaining patent
portfolio, of approximately $4.0 million, over the current estimated life of the
currently utilized core technologies, which is two years.

GAIN ON SALE OF SHARES OF JOINT VENTURE

        On December 31, 1997, the Company entered into an agreement to sell to
UMC 80 million shares of USC stock for a purchase price of 2.4 billion New
Taiwan dollars. The Company received the purchase price (approximately $68.0
million in cash) in January 1998 upon closing. The gain on the sale of stock of
USC was $26.6 million.

        In June 1999, the Company amended its agreements with UMC. Under the
terms of the amended agreements, UMC has agreed to pay the Company, subject to
certain conditions, 1.4 billion New Taiwan dollars (approximately U.S. $43.3
million at exchange rates prevailing on June 30, 1999) and the Company has
agreed to release UMC from contingencies associated with the sale of 80 million
shares of stock of USC in January 1998 and to grant a license to patents
covering multimedia products and integrated circuit manufacturing technology
for use in products manufactured by UMC. Payments will be received over five
fiscal quarters beginning in the quarter ended June 30, 1999.

OTHER INCOME (EXPENSE), NET

       Other income was $0.3 million for the three months ended June 30, 1999,
an increase of $4.5 million from other expense of $4.2 million for the three
months ended June 30, 1998. Other income was $0.4 million for the six months
ended June 30, 1999, an increase of $4.6 million from other expense of $4.2
million for the six months ended June 30, 1998. The increase in other income for
the three months and six months ended June 30, 1999 was primarily associated
with sublease income the Company received in the three months and six months
ended June 30, 1999.

INCOME TAXES

       The Company's effective tax rates for the three months and six months
ended June 30, 1999 and 1998 are 0% and 42%, respectively. The 1999 effective
tax rate reflects operating losses with no realized tax benefit. The 1998
effective tax rate was applied to income excluding the gain on the sale of
shares of joint venture and write-off of acquired in process technology (for
which the effective tax rate of 38.5% was applied).

EQUITY IN NET INCOME OF JOINT VENTURE

       As discussed in "Liquidity and Capital Resources", the Company entered
into an agreement with other parties to form a separate Taiwanese company, USC.
This investment was accounted for under the equity method of accounting in
reporting the Company's share of results for the entity until June 1999. Equity
in net income of joint venture reflects the Company's share of income earned by
USC for the current quarter. The Company reported $3.1 million and $3.8 million
of equity in net income of joint venture, net of tax for the three months ended
June 30, 1999 and 1998, respectively. The Company reported $4.6 million and $7.5
million of equity in net income of joint venture, net of tax for the six months
ended June 30, 1999 and 1998, respectively.

        In connection with the Company's June 1999 amendment of its agreements
with UMC described above under "Gains on Sale of Shares of Joint Venture," the
Company agreed to waive rights to its USC board seat and determined that it no
longer could exercise significant influence over the financial and operating
decisions of USC. Accordingly, in June 1999 the Company ceased accounting for
its investment in USC using the equity method of accounting.

LIQUIDITY AND CAPITAL RESOURCES

                                       13

<PAGE>   14

       Cash provided by operating activities for the six months ended June 30,
1999 was $13.2 million, as compared to $13.9 million of cash provided by
operating activities for the six months ended June 30, 1998. The Company's net
loss for the six months ended June 30, 1999 was partially offset by depreciation
and amortization expense. In addition, cash provided by operations for the six
months ended June 30, 1999 was favorably impacted by decreases in prepaid taxes,
prepaid expenses and increases in accounts payable, partially offset by
increases in accounts receivable and inventories and decreases in accrued
liabilities and deferred revenue. The Company received an income tax refund in
June of 1999. The changes in prepaids, accounts payable and accrued liabilities
are the result of timing of payments. The Company's net loss for the six months
ended June 30, 1998 was offset by a number of non-cash items including deferred
taxes, depreciation and amortization and the write-off of acquired technologies.
These were offset by the gain on the sale of shares of joint venture and equity
in income from the joint venture. Changes in assets and liabilities include
decreases in accounts receivable, inventories, accounts payable and deferred
revenue. The decrease in accounts receivable for the six months ended June 30,
1998 was the result of lower net sales. The decrease in inventories and accounts
payable for the six months ended June 30, 1998 were attributable to reductions
in inventory procurement resulting from softening demand and the Company's
efforts to reduce inventory balances in its distribution channel. Deferred
revenue for the six months ended June 30, 1998 decreased as distributors sold
through inventory to their end user customers.

       Investing activities used cash of $13.6 million for the six months ended
June 30, 1999 and consisted primarily of issuance of notes receivable to Diamond
Multimedia Systems, Inc., cash received from UMC related to the sale of shares,
purchases of property and equipment, net and the purchase of short term
investments, net, offset by cash received from the sale of USC shares. Investing
activities used $32.0 million during the six months ended June 30, 1998 and
consisted primarily of cash received from the sale of USC shares, offset by cash
used in the technology exchange with Cirrus Logic, Inc. and the purchase of
short term investments, net.

       Financing activities provided cash of $6.1 million and used cash of $10.0
million for the six months ended June 30, 1999 and 1998, respectively. Sales of
common stock, net and the sale of a warrant to Intel Corporation were the
financing activities generating cash during the six months ended June 30, 1999.
Repayment on the line of credit and equipment financing were the principal
financing activities that used cash for the six months ended June 30, 1998.

       In 1995, the Company entered into two long-term manufacturing capacity
arrangements. The Company entered into an agreement with UMC and Alliance
Semiconductor Corporation to form USC, a separate Taiwanese company, for the
purpose of building and managing a semiconductor manufacturing facility in the
Science Based Industrial Park in Hsin Chu City, Taiwan, Republic of China. The
Company invested $53.0 million in 1996 and $36.4 million in 1995 for its 23.75%
equity interest. In January 1998, the Company reduced its equity interest to
15.75% through the sale of a portion of its USC shares, and received
approximately $68.0 million in cash. The facility commenced production utilizing
advanced submicron semiconductor manufacturing processes in late 1996. The
Company has the right to purchase up to 31.25% of the output from the foundry.
In addition, the Company has an agreement with TSMC to provide additional
capacity over the 1996 to 2002 timeframe. The agreement with TSMC requires the
Company to make certain annual advance payments to be applied against the
following year's capacity. The Company has signed promissory notes to secure
these payments, which totaled $14.4 million as of June 30, 1999.

       Working capital at June 30, 1999 and December 31, 1998 was $139.4 million
and $152.2 million, respectively. At June 30, 1999, the Company's principal
sources of liquidity included cash and equivalents of $36.6 million and $94.8
million in short-term investments. The Company's principal sources of liquidity
at December 31, 1998 included cash and equivalents of $31.0 million and $88.6
million of short-term investments. The Company believes that its available funds
will satisfy the Company's projected working capital and capital expenditure
requirements for at least the next 12 months, other than expenditures for future
potential manufacturing agreements.

     In July 1999, the Company loaned Diamond Multimedia Systems $10.0 million
under its credit agreement with Diamond described in Note 9 of Notes to
Unaudited Condensed Consolidated Financial Statements. Because of Diamond's
liquidity position and resulting cash constraints, which resulted from its
working capital requirements and continued investments in new product lines such
as the Rio Internet audio player and HomeFree line of home networking products,
in July 1999, Diamond assigned its rights to acquire OneStep, LLC, to S3 and S3
acquired OneStep for approximately $10.0 million in cash. OneStep is a software
development company that supplies the Rio Audio Manager for Diamond's Rio
Internet audio players. Under its agreements with S3, Diamond is currently
funding the operating expenses of OneStep and S3 has licensed to Diamond's
wholly owned subsidiary, RioPort.com, Inc., OneStep's intellectual property.
Diamond currently intends to carve out RioPort as an independently managed
company funded by outside investors, while maintaining a substantial equity
position in RioPort. At the same time as RioPort's planned venture capital
financing, S3 intends to sell OneStep to RioPort in exchange for cash and shares
of RioPort stock.

     In order to obtain an adequate supply of wafers, especially wafers
manufactured using advanced process technologies, the Company has entered into
and will continue to consider various possible transactions, including the use
of "take or pay" contracts that commit the Company to purchase specified
quantities of wafers over extended periods, equity investments in, advances or
issuance of equity securities to wafer manufacturing companies in exchange for
guaranteed production or the formation of joint ventures to own and operate or
construct wafer fabrication facilities. Manufacturing arrangements such as these
may require substantial capital investments, which may require the Company to
seek additional equity or debt financing. There can be no assurance that such
additional financing, if required, will be available when needed or, if
available, will be on satisfactory terms. In addition, the Company may, from
time to time, as business conditions warrant, invest in or acquire businesses,
technology or products that complement the business of the Company.


                                       14

<PAGE>   15

     The Company is currently a party to certain legal proceedings. Litigation
could result in substantial expense to the Company. See "Part II- Item 1. Legal
Proceedings."

Year 2000 Compliance

     As a result of computer programs being written using two digits, rather
than four, to represent year dates, the performance of our computer systems and
those of our suppliers and customers in the Year 2000 is uncertain. Any computer
programs that have time-sensitive software may recognize a date using "00" as
the year 1900 rather than the year 2000. This could result in a system failure
or miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices or engage
in other normal business activities.

     Our plans to address the Year 2000 issue involve the following phases: (i)
inventory/risk assessment, (ii) remediation, (iii) testing and (iv) full
compliance and/or the creation of contingency plans. We have completed an
inventory and assessment of our systems for Year 2000 readiness. The assessment
indicated that most of our significant information technology systems could be
affected, particularly the general ledger, billing and inventory systems. That
assessment also indicated that software and hardware (embedded chips) used in
development, production and manufacturing systems also are at risk. Based on a
review of our product line, we believe that our products do not require
remediation to be Year 2000 compliant. Accordingly, we believe that our products
will not expose us to material Year 2000 related liabilities. We have also
queried our significant suppliers and subcontractors that do not share
information systems with us ("external agents"). Although we are not aware of
any external agent with a Year 2000 issue that would materially affect our
results of operations or financial condition, the failure of an external agent
to be Year 2000 compliant could have a material adverse effect on our results of
operations or financial condition. We intend to periodically review our external
agents to monitor their progress toward completion of their Year 2000
compliance.

     We have completed the remediation phase for our information technology
systems and expect to complete software reprogramming and replacement by the
third quarter of 1999. Once software is reprogrammed or replaced for a system,
we begin testing and implementation. These phases run concurrently for different
systems. To date, we have completed approximately 90% of our testing. Completion
of the testing phase for all remediated systems is expected to occur by the end
of August 1999, with all remediated systems fully tested and implemented by the
third quarter of 1999. Our order entry system interfaces directly with
significant third party vendors. We have completed the process of working with
third party vendors to ensure that our systems that interface directly with
third parties are Year 2000 compliant.

     We will utilize both internal and external resources to reprogram, or
replace, test and implement our software and operating equipment for Year 2000
modifications. We believe that costs for remediation, testing and implementation
are not expected to exceed $0.3 million.

     We have completed 100% of our contingency plans in the event we do not
complete all phases of the Year 2000 program. The failure of either our critical
systems or those of our material third parties to be Year 2000 compliant would
result in the interruption of our business, which could have a material adverse
affect on our results of operations or financial condition.


FACTORS THAT MAY AFFECT OUR RESULTS

Our Operating Results May Fluctuate

     Our operating results have in the past varied significantly and are
expected to vary significantly in the future due to several factors, many of
which are beyond our control. Any one or more of the factors listed below or
other factors could cause us to fail to achieve our revenue or profitability
expectations. The failure to meet market expectations could cause a sharp drop
in our stock price. Those factors include:

     -    our ability to develop, introduce and market successfully new or
          enhanced products;

     -    changes in our pricing policies or those of our competitors or
          suppliers;

                                       15
<PAGE>   16

     -    competitive pressures on average selling prices;

     -    the availability and cost of products from our suppliers;

     -    changes in demand for our products and our customers' products;

     -    changes in the mix of products sold by us or in the mix of
          distribution channels through which those products are sold;

     -    the timing of new product introductions by us or our competitors;

     -    market acceptance of new or enhanced versions of our products;

     -    disruptions in our production or shipping processes, including
          production delays;

     -    rapid changes in electronic commerce with respect to our or our
          customers may not capitalize or which erode our traditional business
          base;

     -    the gain or loss of significant customers or strategic relationships;

     -    the availability of wafer capacity using advanced process
          technologies;

     -    product obsolescence and the management of product transitions;

     -    seasonal customer demand;

     -    mergers or acquisitions; and

     -    general economic conditions, including economic conditions in Asia in
          particular, that could affect the timing of customer orders and
          capital spending and result in order cancellations or rescheduling.

     Some or all of these factors could adversely affect demand for our products
and, therefore, our operating results, in the future.

     Most of our operating expenses are relatively fixed in the short term. We
may be unable to rapidly adjust spending to compensate for any unexpected sales
shortfall, which could harm quarterly operating results. Because the lead times
of firm orders are typically short in the graphics industry, we do not have the
ability to predict future operating results with any certainty. Therefore,
sudden changes that are outside of our control such as general economic
conditions or the actions or inaction of competitors or customers may materially
and adversely affect our performance.

     In addition, we generally ship more products in the third month of each
quarter than in either of the first two months of the quarter, with levels of
shipment in the third month higher towards the end of the month. This pattern,
which is common in the semiconductor industry, is likely to continue and makes
future quarterly operating results less predictable.

We Experienced Net Losses for Several Recent Quarters And May Experience Net
Losses Again In The Future

     Although we reported net income of $1.1 million for the three months ended
June 30, 1999, we incurred operating losses of $9.5 million in that quarter and
had net losses for the quarter ended March 31, 1999 and for all of 1998. Those
losses occurred primarily because we did not offer competitive products in the
high end of the graphics and multimedia accelerator market. As a result, our
sales consisted primarily of older generation and lower margin products that
were sold into markets that had significant price competition. The results of
any one quarter are not indicative of results to be expected in future quarters
or for a full fiscal year.

We May Not Be able to Realize the Expected Benefits of our Recently Announced
Merger With Diamond Multimedia Systems, Inc., and The Merger May Have Certain
Negative Results

     S3 and Diamond Multimedia Systems, Inc. recently entered into a merger
agreement with the expectation that the merger will result in benefits to the
combined company, including faster time to market with new products and
increased cost efficiencies. If we are not able to integrate effectively our
technologies, operations and personnel in a timely and efficient manner, then
the benefits of

                                       16


<PAGE>   17

the merger may not be realized and, as a result, our operating results and the
market price for our common stock may be adversely affected. The difficulties,
costs and delays involved in integrating the companies, which may be
substantial, may include:

     -    distracting management and other key personnel, particularly senior
          engineers involved in product development and product definition, from
          the business of the combined company;

     -    perceived and potential adverse changes in business focus or product
          offerings;

     -    potential incompatibility of business cultures;

     -    costs and delays in implementing common systems and procedures,
          particularly in integrating different information systems; and

     -    inability to retain and integrate key management, technical, sales and
          customer support personnel.

      The announcement and consummation of the merger may disrupt Diamond's
relationships with certain suppliers of graphics chips who compete with S3. If
Diamond loses one or more of these suppliers, it may lose customers that want
Diamond's products to contain components from those suppliers, a result that
could significantly reduce Diamond's revenue contribution to the combined
company.

      Similarly, the announcement and consummation of the merger is expected to
cause some of S3's add-in card and motherboard customers to end or curtail their
relationships with the combined company. This is expected because the combined
company's products will comprise both graphics chips and graphics boards. Thus,
the combined company will be competing with many of S3's current customers who
are graphics board manufacturers.

      The merger is also expected to result in the combined company being
dependent on a limited source of graphics chips and graphics boards, primarily
because S3 and Diamond each is a supplier to the other. Such dependence exposes
the combined company to heightened risks because one company's supplies or
suppliers may not meet the other company's requirements.

      The merger will result in substantial expense by both S3 and Diamond,
currently estimated at approximately $16.7 million in the aggregate, which could
hurt the earnings of the combined company and divert resources from other
productive uses.

      We are filing with the Securities and Exchange Commission a registration
statement on Form S-4 that sets forth, under the caption "Risk Factors,"
additional risks associated with the proposed merger and risks associated with
the combined company. Stockholders should review that discussion carefully for
a description of those risks.

Our Products Are Subject to Significant Pricing Pressures

      Prices for graphics accelerators tend to decline over time, and prices for
newly introduced products are under significant pricing pressures due in part to
aggressive pricing from some of our competitors. We have experienced and
anticipate that we will continue to experience increased pricing pressures on
average selling prices for our ViRGE, Trio and Savage families of accelerators.

We Have Only Recently Started to Offer Products Intended to Address All
Performance Segments of the Commercial and Consumer PC Market

      The desktop graphics accelerator market has recently transitioned from 2D
acceleration to 3D acceleration. Products that compete in the high performance
segment of that market have higher gross margins than products in the mainstream
PC or in the sub-$1,000, or "segment zero," PC market. We commenced shipment of
our Savage3D product during the third quarter of 1998. This product was intended
to address the high performance 3D acceleration market. The Savage3D failed to
achieve significant market acceptance. As a result, our products only addressed
the lower margin segments of the market, which contributed to our net losses in
recent periods. We recently commenced shipments of our Savage4 product, which is
designed to compete in multiple performance segments of the commercial and
consumer PC markets and to satisfy multiple-function market needs, such as
graphics, video and DVD support. We do not know whether Savage4 will be able to
compete successfully in those segments. If we are not able to introduce and
successfully market higher performance products, our gross margin and
profitability could be negatively affected.

We May Not Adequately Forecast Demand For Our Products

                                       17
<PAGE>   18

     Because we are "fabless" and must order products and build inventory
substantially in advance of product shipments, and because the markets for our
products are volatile and subject to rapid technological and price changes, we
might forecast product demand incorrectly and produce excessive or insufficient
inventories of particular products. In addition, our customers may change
delivery schedules or cancel orders without significant penalty. If we produce
excessive or insufficient inventories of particular products, our operating
results could be negatively affected, as they were in 1998.

    Changes in demand in the graphics chips markets could be large and sudden.
Since graphics board manufacturers often build inventories during periods of
anticipated growth, they may be left with excess inventories if growth slows or
if they have incorrectly forecasted product transitions. In such cases, the
manufacturers may abruptly stop purchasing additional inventory from suppliers
such as us until the excess inventory has been used.

We Face Substantial Competition

     The market for our products is extremely competitive and is characterized
by declining selling prices over the life of a particular product and rapid
technological changes. Our principal competitors for graphics accelerators
include 3Dfx Interactive, Inc., ATI Technologies, Inc., Intel Corporation,
Matrox Graphics Inc., NVIDIA Corporation, and Trident Microsystems, Inc. Our
principal competitors in the multimedia market include the companies just named
as well as a number of smaller companies that may have greater flexibility to
address specific market needs. Potential competitors in these markets include
both large and emerging domestic and foreign semiconductor companies. In
particular, there are a significant number of established and emerging companies
that have developed, are developing or have announced plans to develop 3D
graphics chips. Our product offerings may not address the demand for the next
generation of accelerators or be competitive. If we expand our product line to
add products with additional functionality, we will encounter substantial
competition from established semiconductor companies and may experience
competition from companies designing chips based on different technologies.
Because of the substantial competition that we face, we are subject to a
constant and increasing risk of losing customers to our competitors.

     Furthermore, the need of PC manufacturers to rapidly introduce a variety of
products aimed at different segments of the PC market may lead to the shift by
system OEMs to the purchase of graphics and multimedia add-in cards provided by
others. Some of our competitors supply both add-in cards and accelerator chips,
which may provide those competitors with an advantage over suppliers that offer
only accelerator chips. In addition, some of our potential competitors, such as
Intel, that supply add-in cards and/or motherboards may seek to use their
card/board business to leverage their graphics accelerator business. Some of our
current and potential competitors have greater technical, manufacturing,
financial and marketing resources than we do. We believe that our ability to
compete successfully will depend upon a number of factors both within and
outside of our control, including:

    -   product performance and quality;

    -   product features;

    -   product availability;

    -   manufacturing capabilities and cost of manufacturing;

    -   reputation for quality and strength of brand;

    -   the prices that we charge;

    -   the timing of new product introductions by us and our competitors;

    -   the emergence of new graphics and PC standards;

    -   the level of customer support we offer; and

    -   industry and general economic trends.

     We may not have the financial resources, technical expertise or marketing,
distribution and support capabilities to compete successfully.

                                       18


<PAGE>   19

Our Success Depends Upon Our Ability to Develop New Products and Keep Pace with
Rapid Technological Change

     The PC industry in general, and the market for our products in particular,
is characterized by rapidly changing technology, evolving industry standards and
frequent new product introductions. Products in our market typically have a life
cycle of 12 to 18 months, with regular reductions of unit average selling prices
over the life of a specific product. The successful development and
commercialization of new products required to replace or supplement existing
products involve many risks, including the identification of new product
opportunities, the successful and timely completion of the development process
and the selection of our products by leading systems suppliers and add-in card
and motherboard manufacturers for design into their products. There can be no
assurance that we will successfully identify new product opportunities and
develop and bring to market new products in a timely manner. Furthermore, there
can be no assurance that products or technologies developed by others will not
render our products or technologies noncompetitive, or that our products will be
selected for design into its customers' products.

     Our products are designed to improve the graphics and multimedia
performance of Pentium-based PCs and Microsoft Windows, Windows NT and IBM OS/2
operating systems. We expect that additional specialized graphics processing and
general purpose computing capabilities will be integrated into future versions
of Intel and other Pentium-based microprocessors and that standard multimedia
accelerators in the future will likely integrate memory, system logic, audio,
communications or other additional functions. In particular, Intel and others
have announced plans to develop chips that integrate graphics and processor
functions to serve the lower cost PC market. A substantial portion of our 1998
sales were derived from products addressing the lower cost PC market, and we
anticipate that a substantial portion of our 1999 sales will also be derived
from products addressing that market. We have not previously offered integrated
graphics/core logic accelerator products that provide these functions, which
have traditionally been provided by separate single function chips or chipsets.
We have and intend to continue to expand the scope of our research and
development efforts to provide these functions, which will require that we hire
engineers skilled in these respective areas and promote additional coordination
among our design and engineering groups. Alternatively, we may find it necessary
or desirable to license or acquire technology to enable us to provide these
functions, and there can be no assurance that any such technology will be
available for license or purchase on terms acceptable to us.

     Furthermore, there is a limited amount of space on PC motherboards, and
companies that offer solutions that provide the greatest amount of functionality
within this limited space may have a competitive advantage. While our strategy
is to develop new and enhanced graphics and multimedia accelerator products that
will be complementary to present and future versions of Intel and other
Pentium-based microprocessors and integrate additional functionality, there can
be no assurance that we will be able to develop such new or enhanced products in
a timely manner or correctly anticipate the additional functionality that will
be needed to compete effectively in this market. Our initial product containing
a number of additional functions, Plato/PX, has been discontinued. There can be
no assurance that, if developed, our new or enhanced products that incorporate
additional functions will achieve market acceptance.

     We are continually developing new products, such as Savage4, to address
changing market needs. If new products are not brought to market in a timely
manner or do not address market needs or achieve market acceptance, then our
operating results could be negatively affected. Market acceptance of our
products depends upon a number of factors, some of which are significantly
beyond our control, including the acceptance of other components, such as
memory, that our products are designed to work with. In the past, our business
has been seriously harmed when we developed products that failed to achieve
significant market acceptance. This could occur in the future as well.

We Must Keep Pace with Evolving Industry Standards

     Our products are designed to improve the graphics and multimedia
performance of Pentium-based PCs and Microsoft Windows, Windows NT and IBM OS/2
operating systems, the predominant standards in today's PC market. Any shift
away from such standards would require us to develop new products. We cannot be
certain that new technological developments or changes in standards will not
result in decreased demand for graphics and multimedia accelerators or for our
products that are not compatible with such changed standards.

     In 1996, for example, there was an absence of an industry standard 3D
graphics API. As a result, we developed and promoted our proprietary API.
Microsoft has since introduced its Direct3D API and Silicon Graphics has
introduced OpenGL, which have emerged as the standard APIs for 3D acceleration.
While our 3D accelerators currently support our proprietary API, Direct3D API
and OpenGL, it is possible that another API will emerge as an industry standard
and that our accelerators will not support such a new standard, which would have
a materially negative effect on our business, financial condition and results of
operations.

                                       19
<PAGE>   20

     Furthermore, due to the widespread industry acceptance of Intel's
microprocessor architecture and interface architecture, including its AGP bus,
Intel exercises significant influence over the PC industry generally. From time
to time, Intel significantly modifies its existing technology, architecture and
standards. If we fail to develop products that are compatible with such
modifications, that failure would have a material adverse effect on our
business, financial condition and results of operations. Likewise, any delay in
the public release of information relating to any such modifications could have
a material adverse effect on us.

We are a Fabless Semiconductor Company and Depend on Independent Foundries for
the Manufacture of Our Products

     We currently rely on two independent foundries to manufacture all of our
products either in finished form or wafer form. We have a "take or pay" contract
with Taiwan Semiconductor Manufacturing Company ("TSMC") and a joint venture
foundry, United Semiconductor Corporation ("USC"). We have an agreement with
TSMC to provide additional capacity through 2002. The foundry agreement with
TSMC requires us to make certain annual advance payments to purchase specified
committed capacity amounts to be applied against the following year's capacity
or to forfeit advance payments against those amounts. In the fourth quarter of
1998, we wrote off approximately $4.0 million of the 1998 prepaid production
capacity because we did not fully utilize the capacity related to the advance
payment. As of June 30, 1999, our current note payable to TSMC was $14.4
million. If we purchase excess inventories of particular products or choose to
forfeit advance payments, our operating results could be harmed.

    In June 1999, we entered into an agreement with United Microelectronics
Corporation, the majority owner of the USC foundry joint venture, under which
we gave up our rights to elect a director on USC's board. UMC has also
announced plans to merge USC with UMC, with USC shareholders, including S3, to
receive UMC shares. We will lose our ability to influence the USC board and any
veto power we had over actions to be taken by USC. As a result, our
relationship with USC will be based on our foundry capacity agreement rather
than a joint venture. Although we are currently unaware of any changes that UMC
may propose in the future to the foundry relationship, we will have less
ability to influence whether changes that could be adverse to us will be made
in the future.

     We conduct business with one of our current foundries by delivering written
purchase orders specifying the particular product ordered, quantity, price,
delivery date and shipping terms. This foundry is therefore not obligated to
supply products to us for any specific period, in any specific quantity or at
any specific price, except as may be provided in a particular purchase order. To
the extent a foundry terminates its relationship with us or our supply from a
foundry is interrupted or terminated for any other reason, such as a natural
disaster or an injunction arising from alleged violations of third party
intellectual property rights, we may not have a sufficient amount of time to
replace the supply of products manufactured by that foundry. We may be unable to
obtain sufficient advanced process technology foundry capacity to meet customer
demand in the future. From time to time, we may evaluate potential new sources
of supply. However, the qualification process and the production ramp-up for
additional foundries has in the past taken, and could in the future take, longer
than anticipated. Accordingly, there can be no assurance that such sources will
be able or willing to satisfy our requirements on a timely basis or at
acceptable quality or per unit prices.

     TSMC and USC are both located in the Science-Based Industrial Park in Hsin
Chu City, Taiwan. We currently expect these foundries to supply the substantial
portion of our products in 1999. Disruption of operations at these foundries for
any reason, including work stoppages, political or military conflicts, fire,
earthquakes or other natural disasters, would cause delays in shipments of our
products, and could have a material adverse effect on our operating results. In
addition, as a result of the rapid growth of the semiconductor industry based in
the Science-Based Industrial Park, severe constraints have been placed on the
water and electricity supply in that region. Any shortages of water or
electricity could adversely affect our foundries' ability to supply our
products, which could have a material adverse effect on our operating results.

The Manufacturers On Which We Depend May Experience Manufacturing Yield Problems
That Could Increase Our Per Unit Costs And Otherwise Jeopardize The Success Of
Our Products

     Our products are graphics chips. Graphics chips are difficult to make.
Their production requires a complex and precise process that often presents
problems that are difficult to diagnose and time consuming or expensive to
solve. As a result, companies like ours often experience problems in achieving
acceptable wafer manufacturing yields. Our chips are manufactured from round
wafers made of silicon. During manufacturing, each wafer is processed to contain
numerous individual integrated circuits, or chips. We may reject or be unable
to sell a percentage of wafers or chips on a given wafer because of:

     -  minute impurities,

     -  difficulties in the fabrication process,

     -  defects in the masks used to print circuits on a wafer,

     -  electrical performance,

     -  wafer breakage, or

     -  other factors.

We refer to the proportion of final good chips that have been processed,
assembled and tested relative to the gross number of chips that could be
constructed from the raw materials as our manufacturing yields. These yields
reflect the quality of a particular wafer. Depending on the specific product,
S3 has negotiated with its manufacturers to pay either an agreed upon price for
all wafers or a price that is typically higher for only wafers of acceptable
quality. If the payment terms for a specific product require us to pay for all
wafers, and if yields associated with that product are poor, we bear the risk
of those poor manufacturing yields.

We Rely On Third Parties to Assemble and Test Our Products

     Our products are assembled and tested by a variety of independent
subcontractors. Our reliance on independent assembly and testing houses to
provide these services involves a number of risks, including the absence of
adequate availability of certain packaging technologies, the absence of
guaranteed capacity and reduced control over delivery schedules, quality
assurance and costs.

                                       20
<PAGE>   21
Commitments We Have Made to Obtain Manufacturing Capacity Could Expose Us to
Significant Financial Risks and Give Rise to Future Capital Needs

     In order to obtain an adequate supply of wafers, especially wafers
manufactured using advanced process technologies, we have entered into and may
consider in the future various transactions, including:

     -    the use of "take or pay" contracts that commit us to purchase
          specified quantities of wafers over extended periods;

     -    equity investments in or advances or issuance of equity securities to
          wafer manufacturing companies in exchange for guaranteed production
          capacity; or

     -    the formation of joint ventures to own and operate or construct
          foundries or to develop certain products.

     Any of those transactions would involve financial risk to us and could
require us to commit substantial capital or provide technology licenses in
return for guaranteed production capacity.

     In particular, we have entered into a "take or pay" contract with TSMC and
have entered into the USC joint venture. The need to commit substantial capital
may require us to seek additional equity or debt financing. Although we
currently believe that the need for such additional capital will be minimal for
the next two years, if such capital is needed, the sale or issuance of
additional equity or convertible debt securities could result in additional
dilution to our stockholders. There can be no assurance that such additional
financing, if required, will be available when needed or, if available, will be
on terms acceptable to us. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources" and "Business -- Manufacturing and Design Methodology" in our Annual
Report on Form 10-K for the fiscal year ended December 31, 1998.

Our Sales are Concentrated within a Limited Number of Customers

     We expect a significant portion of our future sales to remain concentrated
within a limited number of strategic customers. If we lose one or more of these
customers, our operating results would be harmed.

     Two customers, IBM Corporation and Creative Technology Ltd. and two
distributors, Synnex Technology Inc. and Promate Electronic Co. accounted for
17%, 10%, 17% and 10% of net sales, respectively, for the three months ended
June 30, 1999. Synnex Technology, Inc. and Promate Electronic Co. and one
customer, Compaq Computer Co. accounted for 43%, 11% and 10% of net sales,
respectively, for the three months ended June 30, 1998. IBM Corporation, Synnex
Technology Inc. and Promate Electronic Co. accounted for 25%, 21% and 12% of net
sales, respectively, for the six months ended June 30, 1999. Synnex Technology
Inc., Promate Electronic Co. and Compaq Computer Co. accounted for 37%, 12% and
11% of net sales for the six months ended June 30, 1998. We expect a significant
portion of our future sales to remain concentrated within a limited number of
strategic customers. There can be no assurance that we will be able to retain
our strategic customers or that these customers will not otherwise cancel or
reschedule orders, or in the event of canceled orders, that such orders will be
replaced by other sales.

Our Sales May Be Hurt by Shortages of Components and Product Defects

     PC graphics and multimedia subsystems include, in addition to our products,
a number of other components that are supplied by third-party manufacturers. Any
shortage of such components in the future could negatively impact our business
and operating results.

     Furthermore, it is possible that our products may be found to be defective
after we have already shipped significant volumes. If that were to occur, there
can be no assurance that we would be able to correct such defects successfully
or that such corrections would be acceptable to our customers. The occurrence of
such an event could have a materially negative effect on our business and
operating results.

We Depend on Sales Through Distributors

     A substantial percentage of our products are distributed in the
distribution channel through add-in card manufacturers that in turn sell to
value added resellers, system integrators, OEMs and distributors. Accordingly,
we depend on these add-in card manufacturers to assist us in promoting market
acceptance of our products. The board manufacturers that purchase our products
are generally not

                                       21


<PAGE>   22

committed to making future purchases of our products and, therefore, could
discontinue incorporating our products into their graphics boards in favor of a
competitor's product, or for any other reason.

     In addition, our distributors are given limited rights to return products
purchased by them, and we provide our distributors with price protection, which
allows our customers to receive a price adjustment on existing inventory when
our published price is reduced. We have not historically incurred significant
price protection charges, but may do so in the future.

Nearly All of Our Sales Are Made on the Basis of Purchase Orders

     Nearly all of our sales are made on the basis of purchase orders rather
than long-term agreements. As a result, we may commit resources to the
production of products without having received advance purchase commitments from
customers. Any inability to sell products to which we have devoted significant
resources could have a material adverse effect on our business, financial
condition or operating results. In addition, cancellation or deferral of product
orders could result in us holding excess inventory, which could have a material
adverse effect on our profit margins and restrict our ability to fund our
operations.

We Rely on Intellectual Property and Other Proprietary Information That May Not
be Adequately Protected and That May be Expensive to Protect

     The industry in which we compete is characterized by vigorous protection
and pursuit of intellectual property rights. We rely primarily on a combination
of patent, trademark, copyright and trade secret laws, employee and third-party
nondisclosure agreements and licensing arrangements to protect our intellectual
property. If these efforts are not sufficient, our business may suffer from the
piracy of our technology and the associated loss of sales. Also, the protection
provided to our proprietary technology by the laws of foreign jurisdictions,
many of which offer less protection than the United States, may not be
sufficient to protect our technology. It is common in the personal computer
industry for companies to assert intellectual property infringement claims
against other companies. Therefore, our products may also become the target of
infringement claims. These infringement claims or any future ones could cause us
to spend significant time and money to defend our products, redesign our
products or develop or license a substitute technology. We may be unsuccessful
in acquiring or developing substitute technology and any required license may
be unavailable on commercially reasonable terms, if at all. In addition, an
adverse result in litigation could require us to pay substantial damages, cease
the manufacture, use, sale, offer for sale and importation of infringing
products, or discontinue the use of certain processes. Any of those events
could materially harm our business. Litigation by or against us could result in
significant expense to us and could divert the efforts of our technical and
management personnel, regardless of the outcome of such litigation. For example,
in October 1995, Brooktree alleged that some of our products infringed a
Brooktree patent. Defending the resulting lawsuit caused us to incur substantial
expense and diverted the efforts of our technical and management personnel. In a
settlement of that suit, we agreed to pay to Brooktree a license fee and
royalties relating to certain product revenues over a five-year period. However,
even if claims do not have merit, we may be required to dedicate significant
management time and expense to defending ourselves if we are directly sued, or
assisting our customers in their defense of these or other infringement claims
pursuant to indemnity agreements. This could have a negative effect on our
financial results.

We Must Attract, Integrate, Train and Retain Key Personnel Knowledgeable About
Our Business

     Our future success depends in part on the continued service of certain key
engineering, sales, marketing and executive personnel, including highly skilled
semiconductor design personnel and software developers, and our ability to
identify and hire additional personnel. Competition for such personnel is
intense, particularly in the technology sectors and in the regions where our
facilities are located. We cannot be certain that we will be able to retain
existing personnel or attract, hire or retain additional qualified personnel.
The loss of services of any of our senior management team or other key employees
or our failure to attract, integrate, train and retain additional key employees
could harm our business.

We Have Recently Undergone a Management Transition

     In November 1998, we appointed Kenneth F. Potashner as President and Chief
Executive Officer. Our Board of Directors also increased the size of the board
by one, elected Mr. Potashner to fill the newly created vacancy and elected Mr.
Potashner Chairman of the Board. Terry N. Holdt, who returned from his
retirement in January 1998 to assume the role of interim President, Chief
Executive Officer and Chairman of the Board, remains as Vice Chairman of our
Board of Directors. There can be no assurance as to the effects of this
management transition on our business and operating results. The loss of key
personnel could have a material adverse effect on our business and operating
results. We do not maintain key man insurance on any of our employees.

                                       22


<PAGE>   23

We Have Significant Exposure to International Markets

     Export sales accounted for 82% and 93% of our net sales for the three
months ended June 30, 1999 and 1998, respectively. Export sales accounted for
90% and 86% of our net sales for the six months ended June 30, 1999 and 1998,
respectively. We expect that export sales will continue to represent a
significant portion of net sales, although there can be no assurance that export
sales, as a percentage of net sales, will remain at current levels. In addition,
a substantial proportion of our products are manufactured, assembled and tested
by independent third parties in Asia. As a result, we are subject to the risks
of conducting business internationally, including:

     -    unexpected changes in, or impositions of, legislative or regulatory
          requirements;

     -    fluctuations in the U.S. dollar, which could increase the price in
          local currencies of our products in foreign markets or increase the
          cost of wafers purchased by us;

     -    delays resulting from difficulty in obtaining export licenses for
          certain technology;

     -    tariffs and other trade barriers and restrictions;

     -    potentially longer payment cycles;

     -    greater difficulty in accounts receivable collection;

     -    potentially adverse tax treatment;

     -    the burdens of complying with a variety of foreign laws; and

     -    year 2000 computer malfunctions.

     We have experienced an adverse impact associated with the economic downturn
in Asia that contributed to our decrease in net sales in 1998. In addition, our
international operations are subject to general geopolitical risks, such as
political and economic instability and changes in diplomatic and trade
relationships. Our foundries, TSMC and USC, are located in Taiwan. The People's
Republic of China and Taiwan have in the past experienced and are currently
experiencing strained relations, and a worsening of relations or the development
of hostilities between the two could have a material adverse effect on us.
Finally, the laws of certain foreign countries may not protect our intellectual
property rights to the same extent as do the laws of the United States.

We Have a Significant Level of Debt

     As a result of the sale by us of $103,500,000 aggregate principal amount of
convertible subordinated notes in September 1996, our ratio of long-term debt to
total capitalization has increased, and at June 30, 1999 was 41.2%. The increase
in this ratio is the result of the decrease in our total capitalization as the
result of our net loss for the six months ended June 30, 1999 and the extension
of the note payable to TSMC. The degree to which we are leveraged could
adversely affect our ability to obtain additional financing for working capital
or other purposes and could make us more vulnerable to economic downturns and
competitive pressures. Our significant leverage could also adversely affect our
liquidity, as a substantial portion of available cash from operations may have
to be applied to meet debt service requirements. In the event of a cash
shortfall, we could be forced to reduce other expenditures to be able to meet
such debt service requirements. See "Selected Consolidated Financial Data," and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources" contained in the Company's Annual
Report on Form 10-K for the fiscal year ended December 31, 1998.

Our Stock Price Is Highly Volatile

     The market price of our common stock, like that of the common stock of many
other semiconductor companies, has been and is likely to be highly volatile.
This volatility may result from:

     -    general market conditions and market conditions affecting technology
          and semiconductor stocks generally;

     -    actual or anticipated fluctuations in our quarterly operating results;

                                       23
<PAGE>   24

     -    announcements of design wins, technological innovations, acquisitions,
          investments or business alliances by us or our competitors; and

     -    the commencement of, developments in or outcome of litigation.

     The market price of our common stock also has been and is likely to
continue to be significantly affected by expectations of analysts and investors,
especially if our operating results do not meet those expectations. Reports and
statements of analysts do not necessarily reflect our views. The fact that we
have in the past met or exceeded analyst or investor expectations does not
necessarily mean that we will do so in the future.

     In the past, following periods of volatility in the market price of a
particular company's securities, securities class action litigation has often
been brought. This litigation could result in substantial costs and a diversion
of our management's attention and resources. Litigation was brought against us
in 1994, and we are currently involved in additional such securities class
action litigation. See "Part II - Item 1. Legal Proceedings."

We Are Party to Legal Proceedings Alleging Securities Violations that Could Have
a Negative Financial Impact on Us

     Since November 1997, a number of complaints have been filed in federal and
state courts seeking an unspecified amount of damages on behalf of an alleged
class of persons who purchased shares of our common stock at various times
between April 18, 1996 and November 3, 1997, referred to as the "class period."
The complaints name us as defendant as well as some of our officers and former
officers and some of our directors, asserting that we and they violated federal
and state securities laws by misrepresenting and failing to disclose certain
information about our business during the class period. In addition,
stockholders have filed derivative actions in the state courts of California and
Delaware seeking recovery on our behalf, alleging, among other things, breach of
fiduciary duties by the individual defendants. Discovery is currently
proceeding. While our management intends to defend the actions against us
vigorously, there can be no assurance that an adverse result or settlement with
regard to these lawsuits would not have a material adverse effect on our
financial condition or results of operations.

     We have also received from the United States Securities and Exchange
Commission a request for information relating to our financial restatement
announcement in November 1997. We have responded and intend to continue to
respond to SEC requests.


Item 3. Quantitative and Qualitative Disclosures About Market Risk.

INVESTMENT PORTFOLIO

     The Company does not use derivative financial instruments in its investment
portfolio. The Company places its investments in instruments that meet high
credit quality standards, as specified in the Company's investment policy. The
Company also limits the amount of credit exposure to any one issue, issuer or
type of investment. The Company does not expect any material loss with respect
to its investment portfolio.

     The table below summarizes the Company's investment portfolio. The table
represents principal cash flows and related average fixed interest rates by
expected maturity date. The Company's policy requires that all investments
mature within twenty months.

     Principal (Notional) Amounts Maturing in 1999 in U.S. Dollars:
<TABLE>
<CAPTION>

                                         FAIR VALUE AT
                                         JUNE 30, 1999
                                      ----------------------
                                         (IN THOUSANDS,
                                      EXCEPT INTEREST RATES)

<S>                                   <C>
Cash and equivalents ..................  $    36,628
Weighted average interest rate ........        4.34%
Short-term investments ................  $    94,795
Weighted average interest rate ........        5.35%
Total portfolio .......................  $   131,423
Weighted average interest rate ........        5.07%
</TABLE>

CONVERTIBLE SUBORDINATED NOTES

                                       24


<PAGE>   25

     In September 1996, the Company completed a private placement of $103.5
million aggregate principal amount of convertible subordinated notes. The notes
mature in 2003. Interest is payable semi-annually at 5 3/4% per annum. The notes
are convertible at the option of the note holders into the Company's common
stock at an initial conversion price of $19.22 per share, subject to adjustment.
Beginning in October 1999, the notes are redeemable at the option of the Company
at an initial redemption price of 102% of the principal amount. The fair value
of the convertible subordinated notes at June 30, 1999 was approximately $ 84.2
million.

IMPACT OF FOREIGN CURRENCY RATE CHANGES

     The Company invoices its customers in US dollars for all products. The
Company is exposed to foreign exchange rate fluctuations as the financial
results of its foreign subsidiaries are translated into US dollars in
consolidation. The foreign subsidiaries maintain their accounts in the local
currency of the foreign location in order to centralize the foreign exchange
risk with the parent company. To date this risk has not been material.

     The effect of foreign exchange rate fluctuations on the Company's financial
statements for the three and six months ended June 30, 1999 and 1998 was not
material. Since foreign currency exposure increases as intercompany receivables
grow, from time to time the Company uses foreign exchange forward contracts as a
means for hedging these balances. As of June 30, 1999, the Company had no
forward exchange contracts.


PART II. OTHER INFORMATION

Item 1.  Legal Proceedings

        On August 4, 1999, two alleged stockholders of Diamond filed a lawsuit,
captioned STRUM v. SCHROEDER, et al., No. CV783708, in the Superior Court of
the State of California for the County of Santa Clara. Plaintiffs, on behalf of
themselves and a class of all Diamond stockholders similarly situated whom they
purportedly represent, challenge the terms of the proposed merger between S3
and Diamond. The complaint names as defendants Diamond, the directors of
Diamond and S3. The complaint alleges generally that Diamond's directors
breached their fiduciary duties to stockholders of Diamond and seeks an
injunction against the merger, or, in the alternative, rescission and the
recovery of unspecified damages, fees and expenses. S3 believes that it has
meritorious defenses to the lawsuit and intends to defend itself vigorously.

        There have been no other material developments in the Company's legal
proceedings since the disclosure of such legal proceedings set forth in the
Company's Form 10-K for the fiscal year ended December 31, 1998 as filed with
the Securities and Exchange Commission on March 26, 1999.

Item 4.  Submission of Matters to a Vote of Security Holders

(a)  The Annual Meeting of Stockholders was held May 17, 1999.

(b)  The matters voted upon at the meeting and results of the voting with
     respect to those matters were as follows:

     (1)  Election of Directors
<TABLE>
<CAPTION>

                                                    Votes For              Withheld
                                                    ---------              --------
<S>                                                 <C>                    <C>
                     Kenneth F. Potashner           48,146,761             407,274
                     Terry N. Holdt                 48,127,059             426,976
                     John C. Colligan               48,137,197             416,838
                     Robert P. Lee                  48,123,700             430,335
                     Carmelo J. Santoro             48,117,597             436,438
                     Ronald T. Yara                 48,131,197             422,838
</TABLE>

     (2) Ratification of Ernst & Young LLP as the Company's independent auditors

                     Votes For              Against            Abstain
                     ---------              -------            -------
                     48,052,699             235,525            265,811

     (3) Amendment to the S3 Incorporated 1989 Stock Plan

                      Votes For              Against              Abstain
                      ---------              -------              -------
                      10,750,946             9,838,025            260,670



                                       25

<PAGE>   26

Item 6.  Exhibits and Reports on Form 8-K

(a)  Exhibits

 2.1   Agreement and Plan of Merger, dated June 21, 1999, between S3
       Incorporated and Diamond Multimedia Systems, Inc. (Incorporated by
       reference to Exhibit 2.1 of the Company's Current Report on Form 8-K
       dated June 25, 1999)

27.1   Financial Data Schedule (filed only with the electronic submission of
       Form 10-Q in accordance with the EDGAR requirements)

(b) Reports on Form 8-K:

The following report on Form 8-K was filed by the Company during the three
months ended June 30, 1999:

      On June 25, 1999, the Company filed a Current Report on Form 8-K with the
Securities and Exchange Commission that disclosed that the Company had entered
into an Agreement and Plan of Merger, dated June 21, 1999 with Diamond
Multimedia Systems, Inc. ("Diamond"). As a result of the merger, Diamond will
become a wholly-owned subsidiary of the Company. The closing of the merger is
subject to certain conditions. That Form 8-K also disclosed that the Company and
Diamond entered into a Credit Agreement dated as of June 10, 1999, and amended
on June 14, 1999, pursuant to which the Company agreed to make three
separate loans to Diamond in amounts not exceeding $20.0 million in the
aggregate. In connection with the loans, Diamond issued to the company three
warrants to purchase an aggregate of 4,597,871 shares of Diamond Common Stock at
exercise prices ranging from $4.18 to $4.471875 per share.



                                       26
<PAGE>   27

                                   SIGNATURES

    Pursuant to the requirements of the Securities Exchange Act of 1934, the
    Registrant has duly caused this report to be signed on its behalf by the
                     undersigned thereunto duly authorized.

                                 S3 INCORPORATED
                                  (Registrant)

                              /s/ WALTER D. AMARAL
                              --------------------
                                WALTER D. AMARAL
                          Senior Vice President Finance
                           and Chief Financial Officer
                  (Principal Financial and Accounting Officer)

                                 August 13, 1999




                                       27

<PAGE>   28
                                INDEX TO EXHIBITS
<TABLE>
<CAPTION>

  EXHIBIT
   NUMBER              DESCRIPTION OF DOCUMENT
  ------               -----------------------

<S>             <C>
      2.1       Agreement and Plan of Merger, dated June 21, 1999, between S3
                Incorporated and Diamond Multimedia Systems, Inc. (Incorporated
                by reference to Exhibit 2.1 to the Company's Current Report on
                Form 8-K dated June 25, 1999)

      27.1      Financial Data Schedule

</TABLE>

                                       28