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, 1997 and March 31, 1997, the results of operations for the quarters and nine months ended December 31, 1997 and December 31, 1996, and the cash flows for the nine months ended December 31, 1997 and December 31, 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 basic earnings per share and diluted earnings per share are computed in accordance with the Statement of Financial Accounting Standards No.128 commencing the quarter ended December 31, 1997. The basic and diluted earnings per share for prior periods are also restated in accordance with the Statement of Financial Accounting Standards No. 128.

The basic earnings per share is computed on the income from continuing operations and net income respectively, available to common stockholders, divided by the weighted average number of common shares outstanding throughout the relevant periods.

The diluted earnings per share is computed on the income from continuing operations and net income respectively, available to common stockholders, divided by the weighted average number of common shares outstanding and the number of additional common shares that outstanding if the dilutive potential common shares had been issued.throughout the relevant periods.

The weighted average number of Common Shares in 1997 and 1996 take 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 periods ended December 31, 1997 and December 31, 1996 respectively.

The net income for the quarter and nine months ended December 31, 1997 and 1996 were both from the Company's continuing 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, 1997 Compared to Three Months Ended December 31, 1996

The Company's net sales for the three months ended December 31, 1997 were $18,993,000, an increase of $5,670,000 or 42.6% as compared to corresponding period in 1996. The increase in sales was mainly related to additional sales of injection-molded plastic, electronic products and metallic products of $1,381,000, $3,946,000 and $343,000 respectively, or increases of 18.7%, 76.4% and 43.4% 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 mainly attributed to the increase in both OEM and sub-contract sales to an existing customer. 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 December 31, 1997 was $8,515,000, representing a gross profit margin of 44.8%. This compares with the overall gross profit and gross profit margin of $5,763,000 or 43.3% for the quarter ended December 31, 1996.

There was a slight increase in the overall gross profit margin of 1.5%. The margin on the sale of plastic parts and components increased to 51.7% as compared to 46.0% in the previous year, with a total gross profit margin contribution of $4,524,000 in 1997, an increase of $1,135,000 from the previous year. The increase in plastic operation margin was mainly attributed to higher margins generated from the assembly work and from the tooling modification requests of an existing customer. The gross profit margin on sales of electronic orders and subassemblies increased slightly to 43.5% compared to 41.2% in the previous year, with a total gross profit contribution of $3,963,000, compared to $2,130,000 in the previous year.

Selling, general and administrative expenses for the quarter ended December 31, 1997 were $3,197,000, amounting to 16.8% of total net sales, as compared to $2,545,000 or 19.1% of total net sales for the quarter ended December 31, 1996. The increase in selling, general and administrative expenses of $652,000 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 $5,318,000 for the quarter ended December 31, 1997, an increase of $2,100,000 or 65.3% 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 $1,344,000 for the quarter ended December 31, 1997 from $625,000 for the quarter ended December 31, 1996 reflects the fact that the electronic business generated significant profits in the current period as compared to the corresponding period in 1996. 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, 1997.

As a result of the above factors, net income was $4,197,000 for the quarter ended December 31, 1997, an increase of $1,464,000 or 53.6%, as compared to the quarter ended December 31, 1996 and net income as a percentage of net sales increased slightly to 22.1% from 20.5%.

Nine Months Ended December 31, 1997 Compared to Nine Months Ended December 31, 1996

The Company's net sales for the nine months ended December 31, 1997 were $51,660,000, an increase of $19,796,000 or 62.1% as compared to corresponding period in 1996. The increase in sales was mainly related to additional sales of injection-molded plastic, electronic and metallic products of $5,633,000, $12,162,000 and $2,001,000 respectively, or increases of 30.7%, 95.6% and 253.3% respectively 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 mainly attributed to the increase in both OEM and sub-contract sales to an existing customer. 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 nine months ended December 31, 1997 was $22,285,000, representing a gross profit margin of 43.1%. This compares with the overall gross profit and gross profit margin of $13,746,000 or 43.1% for the nine months ended December 31, 1996.

The margin on the sale of plastic parts and components increased to 45.6% as compared to 43.0% in the previous year, and the total gross profit margin contributed was $10,948,000 in 1997, an increase of $3,054,000 from the previous year. The slight increase in plastic operation margin was attributed to higher margins generated from the assembly work this year and from the tooling modification requests from an existing customer. The gross profit margin on sales of electronic orders and subassemblies increased slightly to 45.9% compared to 44.1% in the previous year, with a total gross profit contribution of $11,430,000, compared to $5,608,000 in the previous year.

Selling, general and administrative expenses for the nine months ended December 31, 1997 were $9,802,000, amounting to 19.0% of total net sales, as compared to $5,719,000 or 17.9% of total net sales for the nine months ended December 31, 1996. The increase in selling, general and administrative expenses of $4,083,000 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 $12,483,000 for the nine months ended December 31, 1997, an increase of $4,456,000 or 55.5% 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 $2,756,000 for the nine months ended December 31, 1997 from $1,627,000 for the nine months ended December 31, 1996 reflects the fact that the electronic business generated significant profits in the current period as compared to the corresponding period in 1996. 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, 1997.

As a result of the above factors, net income was $10,103,000 for the nine months ended December 31, 1997, an increase of $3,590,000 or 55.1%, as compared to the nine months ended December 31, 1996 and net income as a percentage of net sales decreased to 19.6% 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 December 31, 1997, the Company had a working capital surplus of $29,541,000. 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 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. The Company has no outstanding short-term borrowings and long-term debt at December 31, 1997.

At December 31, 1997, the Company had in place general banking facilities with three financial institutions aggregating approximately $8,656,000. 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, 1997, the Company had ( i ) unused credit facilities of $8,656,000 ( ii ) cash and cash equivalents of $16,811,000 and ( iii ) restricted cash of $2,859,000, 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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