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 September 30, 1997 and March 31, 1997, the results of operations for the quarters and six months ended September 30, 1997 and September 30, 1996, and the cash flows for the six months ended September 30, 1997 and September 30, 1996. The notes to the Consolidated Financial Statements which are contained in the Form 20-F Annual Report filed on July 15, 1997 under the Securities Exchange Act of 1934 should be read in conjunction with these Consolidated Financial Statements.

2. Inventories

3. Earnings Per Share

The primary earnings per share ("EPS") is computed on the net income divided by the weighted average number of Common Shares in issue and the assumed exercise of common stock equivalents that will dilute EPS by 3% or more throughout the relevant periods.

The fully diluted earning per share is computed on the net income divided by the weighted average number of Common Shares in issue, the assumed exercise of common stock equivalents and the assumed exercise of all other potentially dilutive (3% or more) securities that will dilute EPS by 3% or more throughout the relavent periods.

The weighted average number of Common Shares in 1997 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, Advisor and Representatives' Warrants and Public Warrants during the period ended September 30, 1997. The weighted average number of Common Shares in 1996 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 of September 30, 1997 diluted the primary earnings per share and fully diluted earnings per share by 3% or more for the quarter and six months ended September 30, 1997 respectively. The stock options and warrants outstanding as of September 30, 1996 did not dilute the primary earnings per share by 3% or more.

DESWELL INDUSTRIES, INC.
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) electrical 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 September 30, 1997 Compared to Three Months Ended September 30, 1996

The Company's net sales for the three months ended September 30, 1997 were $18,083,000, an increase of $8,110,000 or 81.3% as compared to the corresponding period in 1996. The increase in sales was mainly related to additional sales of injection-molded plastic, electronic products and metallic products of $1,941,000, $5,217,000 and $952,000, respectively, or increases of 33.8%, 123.2% and 100% as compared with the net sales in the corresponding period in the prior year. Revenues from the metallic product operation were generated from a subsidiary that was acquired in October 1996. The substantial increase in sales of electronic products was partly attributed to the increase in sales to an existing customer as a result of a change from sub-contract sales to OEM sales commencing September 1997. Moreover, the Company continues to generate higher volume demand from its customers this year as a result of the Company's continuous efforts to produce high quality products.

The gross profit for the quarter ended September 30, 1997 was $7,511,000, representing a gross profit margin of 41.5%. This compares with the overall gross profit and gross profit margin of $4,489,000 or 45.0% for the quarter ended September 30, 1996.

There was a slight decrease in the overall gross profit margin of 3.5%. The margin on the sale of plastic parts and components increased slightly to 43.3% as compared to 41.4% in the previous year, with a total gross profit margin contribution of $3,325,000 in 1997, an increase of $948,000 from the previous year. The gross profit margin on sales of electronic orders and subassemblies decreased slightly to 45.6% as compared to 49.9% in the previous year, with a total gross profit contribution of $4,308,000, compared to $2,112,000 in the previous year. This was attributable to the above-mentioned change of sub-contract sales to OEM sales to an existing customer where the profit margin of OEM sales was relatively lower than that of Sub-contracting sales despite the increase in sales volume.

Selling, general and administrative expenses for the quarter ended September 30, 1997 were $3,604,000, amounting to 19.9% of total net sales, as compared to $1,714,000 or 17.2% of total net sales for the quarter ended September 30, 1996. The increase in selling, general and administrative expenses of $1,890,000 over the corresponding period was largely due to the increase in payments for research and development support, quality control and engineering supports to the Company, coupled with the growth in the Company's operations. The Company expects to conduct substantially all research and development and quality control work internally in the future.

As a result of the increase in net sales and selling expenses, operating income was $3,907,000 for the quarter ended September 30, 1997, an increase of $1,132,000 or 40.8% 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. The increase in minority interest to $828,000 for the quarter ended September 30, 1997 from $654,000 for the quarter ended September 30, 1996 reflects the fact that the electronics business generated significant profits in the current period as compared to the corresponding period in 1996. As the operation of metallic subsidiary is in the preliminary stage, the operating results and the minority interest effects were not material in the quarter ended September 30, 1997.

As a result of the above factors, net income was $3,227,000 for the quarter ended September 30, 1997, an increase of $1,108,000 or 52.3%, as compared to the quarter ended September 30, 1996 and net income as a percentage of net sales decreased to 17.8% from 21.2%.

Six Months Ended September 30, 1997 Compared to Six Months Ended September 30, 1996

The Company's net sales for the six months ended September 30, 1997 were $32,667,000, an increase of $14,126,000 or 76.2% as compared to the corresponding period in 1996. The increase in sales was mainly related to additional sales of injection-molded plastic, electronic products and metallic products of $4,252,000, $8,216,000 and $1,658,000 respectively, or increases of 38.7%, 108.8% and 100% as compared with the net sales in the corresponding period in the prior year. Revenues from the metallic operation were generated from a subsidiary acquired in October 1996. The substantial increase in sales of electronic products was partly attributed to the increase in sales to an existing customer as a result of a change from sub-contract sales to OEM sales commencing September 1997. Moreover, the Company continues to generate higher volume demands from its customers this year as a result of the Company's continuous efforts to produce high quality products.

The gross profit for the six months ended September 30, 1997 was $13,770,000, representing a gross profit margin of 42.2%. This compares with the overall gross profit and gross profit margin of $7,983,000 or 43.1% for the six months ended September 30, 1996.

There was a slight decrease in the overall gross profit margin of 0.9%. The margin on the sale of plastic parts and components increased to 42.2% as compared to 41.0% in the previous year, with a total gross profit margin contribution of $6,424,000 in 1997, an increase of $1,919,000 from the previous year. The gross profit margin on sales of electronic orders and subassemblies increased slightly to 47.4% compared to 46.0% in the previous year, with a total gross profit contribution of $7,467,000, compared to $3,478,000 in the previous year. The slight increase of 1.4% in the Company's gross profit margin was mainly attributed to the Company's concentrated efforts on securing orders with higher margin. This was partly offset by the effect of the above-mentioned change of sub-contract sales to OEM sales to an existing customer where the profit margin of OEM sales was relatively lower than that of sub-contract sales.

Selling, general and administrative expenses for the six months ended September 30, 1997 were $6,605,000 amounting to 20.2% of total net sales, as compared to $3,174,000 or 17.1% of total net sales for the six months ended September 30, 1996. The increase in selling, general and administrative expenses of $3,431,000 over the corresponding period was largely due to the increase in payments for providing research and development support, quality control and engineering supports to the Company, coupled with the growth in the Company's operations. The Company expects to conduct all research and development and quality control internally in the future.

As a result of the increase in net sales and selling expenses, operating income was $7,165,000 for the six months ended September 30, 1997, an increase of $2,356,000 or 49.0% 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. The increase in minority interest to $1,412,000 for the six months ended September 30, 1997 from $1,002,000 for the six months ended September 30, 1996 reflects the fact that the electronics business generated significant profits in the current period as compared to the corresponding period in 1996. As the operation of the metallic subsidiary is in preliminary stage, the operating results and the minority interest effects were not material in the period ended September 30, 1997.

As a result of the above factors, net income was $5,906,000 for the six months ended September 30, 1997, an increase of $2,126,000 or 56.2%, as compared to the six months ended September 30, 1996 and net income as a percentage of net sales decreased to 18.1% from 20.4%.

Liquidity and Capital Resources

Traditionally, 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.

At September 30, 1997, the Company had a working capital surplus of $27,025,000. This compares with a working capital surplus of $21,375,000 at March 31, 1997. The increase in working capital was mainly attributed to net cash generated from its operating activities and from the exercise of stock options, representatives' warrants and public warrants during this period.

The Company has generated sufficient funds from its operating activities to finances its operations. 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 no outstanding, short-term borrowings and long-term debt at September 30, 1997.

At September 30, 1997, the Company had in place general banking facilities with three financial institutions aggregating approximately $8,204,000. 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 September 30, 1997, the Company had (I) unused credit facilities of $8,204,000 (ii) cash and cash equivalents of $19,051,000 and (iii) restricted cash of $2,921,000, 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 from the exercise of warrants and stock options.

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