NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands except per share data)

1. Management's Statement

In the opinion of Management, the accompanying unaudited financial statements contain all adjustments (all of which are normal and recurring in nature) necessary to present fairly the financial position of Deswell Industries, Inc. (the Company) at December 31, 1996 and March 31, 1996, the results of operations for the quarters and nine months ended December 31, 1996 and December 31, 1995, and the cash flows for the nine months ended December 31, 1996 and December 31, 1995. The notes to the Consolidated Financial Statements which are contained in the Form 20-F Annual Report filed on July 12, 1996 under the Securities Exchange Act of 1934 should be read in conjunction with these Consolidated Financial Statements.

2. Inventories

3. Public Offering of Common Shares and Warrants

In July 1995, the company completed its initial public offering in the United States (the "IPO") of 1,000,000 Common Shares at $8.625 per share and 1,000,000 Warrants at $0.01 per Warrant (each two Warrants exercisable at $9.056 ($4.528 per Warrant) to purchase one Common Share) and the issuance in August 1995 of an additional 150,000 Common Shares and 150,000 Warrants upon the exercise of the over-allotment option by the underwriters in the IPO. The net proceeds from this offering aggregated approximately $7,903.

In July 1996, Stock Options of 38,500 Common Shares and Advisor's Option of 8,000 Common Shares and 8,000 Warrants were exercised respectively.

4. Earnings Per Share

The primary earnings per share is computed on the net income divided by the weighted average number of Common Shares in issue throughout the relevant periods. The weighted average number of Common Shares in 1996 takes account of the IPO 1,000,000 Common Shares issued in July 1995, the Over-allotment 150,000 Common Shares issued in August 1995 and the additional Common Shares issued upon the exercise of Stock Options and Advisor's Option in July 1996. The weighted average number of Common Shares in 1995 takes account of both the IPO 1,000,000 Common Shares issued in July 1995 and the Over-allotment 150,000 Common Shares issued in August 1995.

The Stock Options and Warrants outstanding as at December 31, 1996 did not dilute the primary earnings per share by 3% or more.

5. Acquisition of Subsidiary

In October 1996, the Company acquired a controlling (33.1%) interest in Kwanta Precision Metal Products Co. Ltd. ("Kwanta") from its three former shareholders for $177 in cash, since which time it has controlled the strategic, financial and operational policies and decisions of Kwanta. This acquisition has been accounted for as a purchase and the results of Kwanta have been included in the consolidated financial statements from the date of acquisition. The cost of acquisition exceeded the fair value of the net assets acquired by $177 and this is recorded as goodwill.

MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Results of Operations

General

The Company's revenues are derived from the manufacture and sale of (i) injection-molded plastic parts and components, (ii) electronic products and subassemblies and (iii) metallic parts and components. The Company carries out all of its manufacturing operations in southern China, where it is able to take advantage of the lower overhead costs and inexpensive labor rates as compared to Hong Kong.

Three Months Ended December 31, 1996 Compared to Three Months Ended December 31, 1995

The Company's net sales for the three months ended December 31, 1996 were $13,323,000, an increase of $5,545,000 or 71.3% as compared to corresponding period in 1995. The increase in sales was mainly related to additional sales of injection-molded plastic, electronic products and metallic products of $2,550,000, $2,205,000 and $790,000 respectively, or increases of 52.9%, 74.5% and 100% as compared with the net sales in the corresponding period in the prior year. The metallic product operation is generated from a newly acquired subsidiary. Moreover, the Company has generated higher volume demands from its customers in this year as a result of the continuous efforts of striving for high quality standards of products.

The gross profit for the quarter ended December 31, 1996 was $5,763,000, representing a gross profit margin of 43.3%. This compares with the overall gross profit and gross profit margin of $3,609,000 or 46.4% for the quarter ended December 31, 1995.

There was a slight decrease in the overall gross profit margin of 3.1%. The margin on the sale of plastic parts and components decreased slightly to 46.0% as compared to 48.6% in the previous year, with a total gross profit margin contribution of $3,389,000 in 1996, an increase of $1,047,000 from the previous year. The gross profit margin on sales of electronic orders and subassemblies decreased slightly 41.2% compared to 42.8% in the previous year, with a total gross profit contribution of $2,130,000, compared to $1,267,000 in the previous year. The gross profit margin on the sales of metallic parts and components was 30.9% in the quarter ended December 31, 1996.

Selling, general and administrative expenses for the quarter ended December 31, 1996 were $2,545,000, amounting to 19.1% of total net sales, as compared to $1,500,000 or 19.3% of total net sales for the quarter ended December 31, 1995. The increase in selling, general and administrative expenses of $1,045,000 over the corresponding period was largely due to the growth in the Company's operations.

As a result of the increase in net sales, operating income was $3,218,000 for the quarter ended December 31, 1996, an increase of $1,109,000 or 52.6% as compared with the corresponding quarter in the prior year.

Minority interests represent the 49% and 66.9% minority interest in the electronics and metallic subsidiaries respectively. The increase in minority interest to $625,000 for the quarter ended December 31, 1996 from $365,000 for the quarter ended December 31, 1995 reflects the fact that the electronic business generated significant profits in the current period as compared to the corresponding period in 1995. As the operation of metallic subsidiary is in preliminary stage, the operating results and the minority interest effects were not material in the quarter ended December 31, 1996.

As a result of the above factors, net income was $2,733,000 for the quarter ended December 31, 1996, an increase of $927,000 or 51.3%, as compared to the quarter ended December 31, 1995 and net income as a percentage of net sales decreased slightly to 20.5% from 23.2%.

Nine Months Ended December 31, 1996 Compared to Nine Months Ended December 31, 1995

The Company's net sales for the nine months ended December 31, 1996 were $31,864,000, an increase of $8,771,000 or 38.0% as compared to corresponding period in 1995. The increase in sales was mainly related to additional sales of injection-molded plastic, electronic and metallic products of $3,976,000, $4,005,000 and $790,000 respectively, or increases of 27.6%, 46.0% and 100% respectively as compared with the net sales in the corresponding period in the prior year. The Company has generated higher volume demands from its customers in this year as a result of the continuous efforts of striving for high quality standards of products.

The gross profit for the nine months ended December 31, 1996 was $13,746,000, representing a gross profit margin of 43.1%. This compares with the overall gross profit and gross profit margin of $9,417,000 or 40.8% for the nine months ended December 31, 1995.

There was a slight increase in the overall gross profit margin of 2.3%. The margin on the sale of plastic parts and components increased to 43.0% as compared to 40.3% in the previous year, and the total gross profit margin contributed was $7,894,000 in 1996, an increase of $2,096,000 from the previous year. The gross profit margin on sales of electronic orders and subassemblies increased as the Company concentrated its efforts on securing orders with higher margins. Gross margins on these products increased to 44.1% compared to 41.5% in the previous year, with a total gross profit contribution of $5,608,000, compared to $3,619,000 in the previous year. The gross profit margin on the sales of metallic parts and components was 30.9% for the nine months ended December 31, 1996.

Selling, general and administrative expenses for the nine months ended December 31, 1996 were $5,719,000, amounting to 17.9% of total net sales, as compared to $3,995,000 or 17.3% of total net sales for the nine months ended December 31, 1995. The increase in selling, general and administrative expenses of $1,724,000 over the corresponding period was largely due to the growth in the Company's operations.

As a result of the increase in net sales, operating income was $8,027,000 for the nine months ended December 31, 1996, an increase of $2,605,000 or 48.0% as compared with the corresponding period in the prior year.

Minority interests represent the 49% and 66.9% minority interest in the electronics and metallic subsidiaries respectively. The increase in minority interest to $1,627,000 for the nine months ended December 31, 1996 from $990,000 for the nine months ended December 31, 1995 reflects the fact that the electronic business generated significant profits in the current period as compared to the corresponding period in 1995. As the operation of metallic subsidiary is in preliminary stage, the operating results and the minority interest effects were not material in the nine months ended December 31, 1996.

As a result of the above factors, net income was $6,513,000 for the nine months ended December 31, 1996, an increase of $2,076,000 or 46.8%, as compared to the nine months ended December 31, 1995 and net income as a percentage of net sales increased to 20.4% from 19.2%.

Liquidity and Capital Resources

Prior to the Company's IPO, the Company has relied primarily upon internally generated funds and short-term borrowings (including trade finance facilities) to finance its operations and expansion, although capital expenditure has been partly financed by long-term debt, including capital leases. After the IPO, the Company has utilized part of its net proceeds of the IPO and its internally generated funds to finance its capital expansion. During the nine months ended December 31, 1996, the Company has increased its net capital assets by $4,375,000.

At December 31, 1996, the Company had a working capital surplus of $16,395,000. This compares with a working capital surplus of $15,353,000 at March 31, 1996. The increase in working capital was mainly attributed to net cash generated from its operations.

The Company has generated sufficient funds from its operating activities to finance its operations and there is little need for external financing other than short-term borrowings which are used to finance accounts receivable and are generally paid from cash generated from operations and long-term debt used to finance capital expenditure. The Company has outstanding short-term borrowings of $60,000 at December 31, 1996 and has no long-term debt outstanding. The Company has repaid all of its long-term capital leases as at December 31, 1996.

At December 31, 1996, the Company had in place general banking facilities with three financial institutions aggregating approximately $8,269,000. Such facilities, which are subject to annual review, include overdrafts, letters of credit, import facilities, trust receipt financing, inward bills financing as well as fixed loans. At December 31, 1996, the Company had (i) unused credit facilities of $8,208,000 (ii) cash and cash equivalents of $7,844,000 and (iii) restricted cash of $2,845,000, which has been pledged as collateral for those credit facilities.

The Company expects that working capital requirements and capital additions will be funded through a combination of internally generated funds, existing facilities and the proceeds of IPO.

Return to Press Release