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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

For the Quarterly Period Ended September 30, 2002

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

Commission File Number 0-23137

REALNETWORKS, INC.
(Exact name of registrant as specified in its charter)

Washington (State of incorporation)		91-1628146 (I.R.S. Employer Identification Number)
2601 Elliott Avenue, Suite 1000 Seattle, Washington (Address of principal executive offices)		98121 (Zip Code)

(206) 674-2700
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  [X]    No [   ]

The number of shares of the registrant’s Common Stock outstanding as of November 11, 2002 was 157,721,220.

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REALNETWORKS, INC.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2002

TABLE OF CONTENTS

		Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements		3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		16
Item 3. Quantitative and Qualitative Disclosures About Market Risk		46
Item 4. Controls and Procedures		47
PART II. OTHER INFORMATION
Item 1. Legal Proceedings		48
Item 6. Exhibits and Reports on Form 8-K		49

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)

						September 30,				December 31,
						2002				2001
ASSETS
Current assets:
	Cash, cash equivalents and short-term investments					$	324,553				344,509
	Trade accounts receivable, net of allowances for doubtful accounts and sales returns						6,356				5,854
	Prepaid expenses and other current assets						6,011				7,244
	Deferred income taxes						—				5,225
			Total current assets				336,920				362,832
Equipment and leasehold improvements, at cost:
	Equipment and software						35,234				31,298
	Leasehold improvements						26,034				24,965
			Total equipment and leasehold improvements				61,268				56,263
	Less accumulated depreciation and amortization						29,525				20,721
			Net equipment and leasehold improvements				31,743				35,542
Restricted cash equivalents							17,300				17,300
Equity investments							27,247				92,940
Deferred income taxes							—				360
Goodwill and other intangible assets, net							61,004				57,816
Other							2,113				1,070
		Total assets				$	476,327				567,860
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
	Accounts payable					$	6,689				9,950
	Accrued and other liabilities						31,524				30,853
	Deferred revenue, excluding non-current portion						32,970				31,462
	Accrued loss on excess office facilities, excluding non-current portion						3,945				5,288
			Total current liabilities				75,128				77,553
Deferred revenue, excluding current portion							14,720				15,380
Accrued loss on excess office facilities, excluding current portion							23,217				7,149
Deferred rent							3,215				2,899
Shareholders’ equity:
	Preferred stock, $0.001 par value per share, no shares issued and outstanding
			Series A: authorized 200 shares				—				—
			Undesignated series: authorized 59,800 shares				—				—
	Common stock, $0.001 par value per share, authorized 1,000,000 shares; issued and outstanding 159,457 shares in 2002 and 159,844 shares in 2001						159				160
	Additional paid-in capital						617,691				628,919
	Deferred stock compensation						(1,469	)			(914	)
	Accumulated other comprehensive income (loss)						(689	)			56,463
	Accumulated deficit						(255,645	)			(219,749	)
			Total shareholders’ equity				360,047				464,879
		Total liabilities and shareholders’ equity				$	476,327				567,860

See accompanying notes to condensed consolidated financial statements

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REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
(in thousands, except per share data)

					Quarters Ended								Nine Months Ended
					September 30,								September 30,
					2002				2001				2002				2001
Net revenues:
	Software license fees				$	15,554				26,751				57,163				84,416
	Service revenues					28,202				16,046				74,466				46,434
	Advertising					1,662				2,431				4,839				12,617
			Total net revenues			45,418				45,228				136,468				143,467
Cost of revenues:
	Software license fees					1,493				1,672				5,305				5,777
	Service revenues					11,720				6,077				29,992				17,217
	Advertising					454				1,418				1,597				4,953
			Total cost of revenues			13,667				9,167				36,894				27,947
			Gross profit			31,751				36,061				99,574				115,520
Operating expenses:
	Research and development (excluding non-cash stock based compensation of $398 and $930 for the quarter and nine months ended September 30, 2002, respectively and $361 and $(9,853) for the comparable periods in 2001, included below)					12,252				12,500				36,846				43,556
	Sales and marketing (excluding non-cash stock based compensation of $0 for the quarter and nine months ended September 30, 2002, and $0 and $(42) for the comparable periods in 2001, respectively, included below)					18,818				17,540				55,501				56,020
	General and administrative					4,561				5,114				14,557				15,832
	Loss on excess office facilities					17,207				5,621				17,207				22,208
	Personnel reduction, restructuring, and related charges					3,595				3,893				3,595				3,893
	Goodwill amortization, acquisitions charges, and stock based compensation					398				12,850				930				27,789
			Total operating expenses			56,831				57,518				128,636				169,298
			Operating loss			(25,080	)			(21,457	)			(29,062	)			(53,778	)
Other income (expense):
	Interest income					1,551				4,171				5,975				14,137
	Equity in net loss of MusicNet					(1,609	)			(1,397	)			(5,132	)			(2,334	)
	Impairment of equity investments					(4,399	)			(2,495	)			(5,103	)			(25,342	)
	Other, net					105				(365	)			3,381				(1,309	)
			Other income (expense), net			(4,352	)			(86	)			(879	)			(14,848	)
Loss before income taxes						(29,432	)			(21,543	)			(29,941	)			(68,626	)
Income tax expense (benefit)						5,957				(2,163	)			5,955				(5,683	)
Net loss					$	(35,389	)			(19,380	)			(35,896	)			(62,943	)
Basic and diluted net loss per share					$	(0.22	)			(0.12	)			(0.22	)			(0.39	)
Shares used to compute basic and diluted net loss per share						159,961				161,203				159,897				160,132
Comprehensive loss:
	Net loss				$	(35,389	)			(19,380	)			(35,896	)			(62,943	)
	Unrealized gain (loss) on investments:
			Unrealized gain (loss) on investments, including taxes of $14,117 and $0 for the quarter and nine months ended September 30, 2002, respectively and $0 for the quarter and nine months ended September 30, 2001			(33,769	)			5,561				(55,468	)			2,367
			Adjustments for losses (gains) reclassified to net loss			—				2,059				(1,705	)			16,519
	Foreign currency translation adjustment					74				97				21				(359	)
		Comprehensive loss			$	(69,084	)			(11,663	)			(93,048	)			(44,416	)

See accompanying notes to condensed consolidated financial statements

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REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

					Nine Months Ended
					September 30,
					2002				2001
Cash flows from operating activities:
	Net loss				$	(35,896	)			(62,943	)
	Adjustments to reconcile net loss to net cash provided by operating activities:
		Depreciation and amortization of equipment and leasehold improvements				8,716				9,026
		Goodwill amortization, acquisition charges and stock based compensation				930				28,189
		Equity in net losses of equity method investees				5,384				2,673
		Accrued loss on excess office facilities				14,725				19,970
		Impairment of equity investments				5,103				25,342
		Income tax benefit related to stock options				—				1,391
		Deferred income taxes				5,585				(7,530	)
		Gain on sale of investment				(2,400	)			—
		Net change in certain operating assets and liabilities				(1,336	)			(6,985	)
			Net cash provided by operating activities			811				9,133
Cash flows from investing activities:
	Purchases of equipment and leasehold improvements					(4,700	)			(12,089	)
	Purchases of short-term investments					(467,682	)			(554,570	)
	Proceeds from sales and maturities of short-term investments					469,145				540,306
	Purchases of long-term equity investments					(2,675	)			(18,878	)
	Decrease in restricted cash equivalents					—				1,500
	Proceeds from sale of equity investments					3,312				—
	Payment of acquisition costs, net of cash acquired					(2,422	)			(1,858	)
			Net cash used in investing activities			(5,022	)			(45,589	)
Cash flows from financing activities:
	Repurchase of common stock					(21,250	)			(750	)
	Proceeds from sale of common stock under employee stock purchase plan and exercise of stock options					6,822				6,835
			Net cash provided by (used in) financing activities			(14,428	)			6,085
Effect of exchange rate changes on cash						10				(570	)
			Net decrease in cash and cash equivalents			(18,629	)			(30,941	)
Cash and cash equivalents at beginning of period						104,182				147,885
Cash and cash equivalents at end of period						85,553				116,944
Short-term investments at end of period						239,000				231,263
Total cash, cash equivalents and short-term investments at end of period					$	324,553				348,207
Supplemental disclosure of non-cash investing activities:
	Common stock issued in business combination, excluding deferred compensation				$	1,003				—

See accompanying notes to condensed consolidated financial statements

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REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) Description of Business

     RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading global provider of software products and services for Internet media delivery. The Company develops and markets software products and services designed to enable users of personal computers and other consumer electronic devices to send and receive audio, video and other multimedia services using the Web.

     Inherent in the Company’s business are various risks and uncertainties, including its limited operating history and the limited history of commerce on the Internet. The Company’s success may depend in part upon the emergence of the Internet and corporate intranets as a communications medium, the acceptance of the Company’s technology and services by the marketplace and the Company’s ability to generate license, service and advertising revenues from the use of its technology and services on the Internet.

(b) Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

     These financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of the Company’s management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and nine months ended September 30, 2002 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2002. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.

     These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.

(c) Cash, Cash Equivalents and Short-Term Investments

     Cash, cash equivalents and short-term investments are comprised of the following (in thousands):

     Restricted cash equivalents represent (a) a restricted escrow account of $10,000,000 established in connection with a lease agreement for the Company’s corporate headquarters that will be maintained for the term of the lease, and (b) cash equivalents held as collateral against a $7,300,000 letter of credit with a bank which represents collateral on the lease of a building located near the Company’s corporate headquarters.

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     The majority of short-term investments mature within twelve months from the date of purchase.

     The Company has classified all marketable debt and equity securities for which there is a determinable fair market value and there are no restrictions on the Company’s ability to sell within the next twelve months as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity, net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income (expense). The cost basis for determining realized gains and losses on available-for-sale securities is determined using the specific identification method. In instances where there are multiple cost bases for the same security, the Company uses the average cost method in determining the cost of the security sold.

(d) Other Investments

     The Company has investments that are accounted for under the cost method of accounting. The cost method is used to account for equity investments in companies in which the Company holds less than a 20 percent voting interest, does not exercise significant influence and the related securities do not have a quoted market price.

     The Company also has investments that are accounted for under the equity method of accounting. Under the equity method of accounting, the Company’s share of the investee’s earnings or loss is included in the Company’s consolidated operating results. In cases where the Company has loaned the investee funds and is the only source of financing, the Company may record more than its relative share of the investee’s losses.

(e) Revenue Recognition

     The Company recognizes revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.”

     Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. If at the outset of the customer arrangement, the Company determines that the arrangement fee is not fixed or determinable or that collectibility is not probable, the Company defers the revenue and recognizes the revenue when the arrangement fee becomes due and payable.

     For multiple element arrangements when Company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, the Company recognizes revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, the Company defers revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognizes the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. If specific objective evidence does not exist for an undelivered element in a software arrangement, which, for the Company, typically relates to the development of complex content delivery networks which include software licenses, consulting services and product support, revenue is recognized over the term of the support period commencing upon delivery of the Company’s technology to the customer.

     Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating the Company’s software to the end user. In the case of prepayments received from an OEM, the Company generally recognizes revenue based on the actual products sold by the OEM. If the Company provides ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue is recognized ratably over the term of the contract.

     Service revenues include GoldPass/RealOne and standalone media subscription services, payments under support and upgrade contracts, fees from consulting services and streaming media content hosting. Media subscription service revenues are recognized ratably over the period that services are provided. Support and upgrade revenues are recognized ratably over the term of the contract, which typically is twelve months. Other service revenues are recognized when the services are performed.

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     Fees generated from advertising appearing on the Company’s Web sites, and from advertising included in the Company’s products and e-commerce and other links in the RealPlayer, RealJukebox and GoldPass/RealOne products, are recognized as revenue over the terms of the contracts. The Company may guarantee a minimum number of advertising impressions, click-throughs or other criteria on the Company’s Web sites or products for a specified period. To the extent these guarantees are not met, the Company defers recognition of the corresponding revenues until guaranteed delivery levels are achieved.

(f) Net Income (Loss) Per Share

     Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period.

     Excluded from the computation of diluted net income (loss) per share for the quarter and nine months ended September 30, 2002 are options and warrants to acquire approximately 36,589,000 shares of common stock with a weighted-average exercise price of $7.24. Also excluded in the quarter and nine months ended September 30, 2002, are approximately 407,000 shares of common stock issued in acquisitions that are subject to repurchase by the Company at a nominal price in certain circumstances. Excluded from the computation of diluted net loss per share for the quarter and nine months ended September 30, 2001 are options and warrants to acquire approximately 35,840,000 shares of common stock with a weighted-average exercise price of $7.87. Also excluded in the quarter and nine months ended September 30, 2001, are approximately 274,000 shares of common stock issued in acquisitions that are subject to repurchase by the Company at a nominal price in certain circumstances. Such potentially dilutive securities are excluded, as their effects are anti-dilutive.

(g) Derivative Financial Instruments

     The Company conducts business internationally in several currencies. As such, it is exposed to adverse movements in foreign currency exchange rates. A portion of this risk is managed using derivative financial instruments, but fluctuations could impact the Company’s results of operations and financial position. The Company’s foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements.

     Generally, the Company’s practice is to manage the majority of its material foreign exchange exposures associated with short-term intercompany balances through the use of foreign currency forward exchange contracts. These contracts require the Company to exchange currencies at rates agreed upon at the contract’s inception. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the short-term intercompany balances, these financial instruments help alleviate the risk that might otherwise result from certain changes in currency exchange rates. The Company does not designate its foreign exchange forward contracts related to short-term intercompany accounts as hedges and, accordingly, the Company adjusts these instruments to fair value through results of operations. However, the Company may periodically hedge a portion of its foreign exchange exposures associated with material firmly committed transactions and long-term investments.

     All derivatives, whether designated in hedging relationships or not, are recorded on the balance sheet at fair value. If the derivative is designated a hedge, then depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through results of operations, or be recognized in other comprehensive income until the hedged item is recognized in results of operations.

     At September 30, 2002, the following foreign currency contracts were outstanding and recorded at fair value (in thousands):

		Contract Amount				Contract Amount
		(Local Currency)				(US Dollars)				Fair Value
British Pounds (“GBP”) (contracts to pay US$/receive GBP)		(GBP)500				$	760			$	17
Japanese Yen (“YEN”) (contracts to pay YEN/receive US$)		(YEN)276,125				$	2,332			$	74

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     No derivative instruments were outstanding at September 30, 2002, which were designated as hedges for accounting purposes.

(h) Comprehensive Loss

     The Company’s comprehensive loss for the quarters and nine months ended September 30, 2002 and 2001 consisted of net loss, net unrealized gains and losses on investments and the gross amount of foreign currency translation adjustments. The tax effect of the foreign currency translation adjustments and unrealized gains and losses on investments has been taken into account if applicable.

     The components of accumulated other comprehensive income (loss) are as follows (in thousands):

(i) New Accounting Policies

     The Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142) effective January 1, 2002. The impact of adopting SFAS 142 is discussed in Note 3.

     In October 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144), which is effective for fiscal years beginning after December 15, 2001. SFAS 144 supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS 121. The Company adopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not affect the Company’s consolidated financial position or results of operations.

     In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146), which is effective for fiscal years beginning after December 31, 2002, with early application encouraged. SFAS 146 supercedes Emerging Issues Task Force Issue No. 94-3, “Liabilities Recognized for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The Company does not expect the adoption of SFAS 146 to have a material effect on its consolidated financial position or results of operations.

NOTE 2 — SEGMENT INFORMATION

     The Company has one reporting segment, media delivery, for which the Company receives revenues from its customers. The Company’s Chief Operating Decision Maker is considered to be the Company’s Chief Executive Officer, President and Chief Financial Officer. The Chief Executive Officer, President and Chief Financial Officer review financial information presented on a consolidated basis accompanied by disaggregated information about products and services and geographical regions for purposes of making decisions and assessing financial performance. The Chief Executive Officer, President and Chief Financial Officer do not review discrete financial information regarding profitability of the Company’s different products or services and, therefore, the Company has only one operating segment as defined by Statement of Financial Accounting Standards No. 131, “Disclosure About Segments of an Enterprise and Related Information.”

     The Company’s customers consist primarily of end users located in the United States and various foreign countries. Revenues by geographic region are as follows (in thousands):

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			Quarters Ended September 30,								Nine Months Ended September 30,
			2002				2001				2002				2001
United States			$	34,048				33,108				98,310				100,961
Europe				6,078				5,815				20,313				21,508
Asia				4,447				4,983				14,697				14,384
Rest of the world				845				1,322				3,148				6,614
	Total net revenues		$	45,418				45,228				136,468				143,467

     The Company generates revenues from four different product types: consumer license and service, consumer subscription services, systems and advertising. Consumer license and service revenues are derived from sales of the Company’s RealPlayer Plus, RealJukebox Plus and other related products, revenues from support and maintenance services that the Company sells to customers who purchase these products and third-party products, including games. Consumer subscription services revenues consist of the Company’s RealOne and related subscription services. Systems revenues are derived from sales of the Company’s media delivery software, including RealServers and Helix system software and related authoring and publishing tools, support and maintenance services sold to customers who purchase these products, broadcast hosting services provided through the Company’s Real Broadcast Network and consulting services the Company offers to its customers. Advertising revenues are derived from sales of advertising on the Company’s Web sites and client software and within the media streams that the Company hosts on behalf of its corporate customers.

Revenues from external customers by product type are as follows (in thousands):

			Quarters Ended September 30,								Nine Months Ended September 30,
			2002				2001				2002				2001
Consumer license and service			$	6,820				11,008				23,500				35,933
Consumer subscription services				21,398				7,970				52,820				18,118
Systems				15,538				23,819				55,309				76,799
Advertising				1,662				2,431				4,839				12,617
	Total net revenues		$	45,418				45,228				136,468				143,467

     Long-lived assets by geographic location are as follows (in thousands):

NOTE 3 — BUSINESS COMBINATIONS, GOODWILL AND INTANGIBLE ASSETS

     In April 2002, the Company acquired, for cash and common stock valued at approximately $5.1 million, a privately held company engaged in the business of developing Internet media software and technology. The purchase price includes amounts payable to certain former shareholders of the acquired company who are eligible to receive additional cash and common stock valued at approximately $3.1 million over a thirty-month period provided that they remain employed by RealNetworks during such period. These costs will be recognized as compensation cost over the related employment period. The acquisition was accounted for as a purchase transaction and, accordingly, RealNetworks’ results include the results for the acquired company since the transaction date. Goodwill of $2.3 million and acquired technology of $0.9 million were recorded as a result of the acquisition. The Company had previously made an equity investment in the acquired company and its investment balance at the time of acquisition was included in the purchase price allocation. Pro forma results are not presented, as they are not material to the Company’s overall financial statements.

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     Goodwill amortization, acquisition charges and stock based compensation are as follows (in thousands):

			Quarters Ended								Nine Months Ended
			September 30,								September 30,
			2002				2001				2002				2001
Goodwill amortization and acquisition charges			$	—				12,489				—				37,684
Stock based compensation				398				361				930				(9,895	)
	Total goodwill amortization, acquisition charges and stock based compensation		$	398				12,850				930				27,789

     In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141, “Business Combinations” (SFAS 141), and SFAS 142. SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. SFAS 141 also specifies certain criteria that intangible assets acquired in a purchase method business combination must meet in order to be recognized and reported apart from goodwill. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (SFAS 121), which was superceded by SFAS 144.

     The provisions of SFAS 141 were adopted effective July 1, 2001. No business combinations were completed during the period from July 1, 2001 to December 31, 2001. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 have been amortized through December 31, 2001.

     As of January 1, 2002, the Company had no recorded intangible assets apart from goodwill of $57.8 million, net of accumulated amortization. During the quarter ended March 31, 2002, the Company completed its transitional goodwill impairment test. Based upon the Company’s analysis, there was no impairment of goodwill upon adoption of SFAS 142 on January 1, 2002. The Company plans to conduct its annual impairment testing during the fourth quarter of each year. As of September 30, 2002, goodwill net of accumulated amortization was $60.1 million and acquired technology was $0.9 million, which is being amortized at $0.3 million per year.

     Net loss and loss per share for the quarter and nine months ended September 30, 2001 adjusted to exclude goodwill amortization expense are as follows (in thousands, except per share data):

				Quarter Ended				Nine Months Ended
				September 30, 2001				September 30, 2001
Net loss:
	Reported net loss			$	(19,380	)			(62,943	)
	Goodwill amortization				12,348				37,044
		Adjusted net loss		$	(7,032	)			(25,899	)
Basic and diluted net loss per share:
	Reported basic and diluted net loss per share			$	(0.12	)			(0.39	)
	Goodwill amortization				0.08				0.23
		Adjusted basic and diluted net loss per share		$	(0.04	)			(0.16	)

     Net loss and net loss per share for the years 2001, 2000 and 1999 adjusted to exclude goodwill amortization expense are as follows (in thousands, except per share data):

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				2001				2000				1999
Net income (loss):
	Reported net income (loss)			$	(74,763	)			(110,121	)			6,926
	Goodwill amortization				49,391				42,413				2,128
		Adjusted net income (loss)		$	(25,372	)			(67,708	)			9,054
Basic net income (loss) per share:
	Reported basic net income (loss) per share			$	(0.47	)			(0.72	)			0.05
	Goodwill amortization				0.31				0.28				0.01
		Adjusted basic net income (loss) per share		$	(0.16	)			(0.44	)			0.06
Diluted net income (loss) per share:
	Reported diluted net income (loss) per share			$	(0.47	)			(0.72	)			0.04
	Goodwill amortization				0.31				0.28				0.01
		Adjusted diluted net income (loss) per share		$	(0.16	)			(0.44	)			0.05

NOTE 4 — OTHER INVESTMENTS

     RealNetworks has made minority equity investments for business and strategic purposes through the purchase of voting capital stock of companies. The Company’s investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term as they are strategic in nature. The Company periodically evaluates whether declines in fair value, if any, of its investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent for which the quoted market price is less than its accounting basis. The Company also considers other factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, the Company considers similar qualitative and quantitative factors and also considers the implied value from any recent rounds of financing completed by the investee. During 2001, certain of the Company’s investments were written down to fair value based upon the Company’s analysis that the declines in fair value were other-than-temporary resulting in impairment charges of $2.5 million and $25.3 million for the quarter and nine months ended September 30, 2001, respectively. Based upon an evaluation of the facts and circumstances at September 30, 2002, the Company determined that other-than-temporary declines in fair value had occurred for two of its privately held investments. As a result, impairment charges of $4.4 million were recorded in the quarter ended September 30, 2002 to reflect changes in the fair value of these investments in results of operations. Additionally, during the quarter ended June 30, 2002, the Company determined that other-than-temporary declines in fair value had occurred for three of its publicly traded investments. Impairment charges for other-than-temporary declines in the fair value of investments for the nine months ended September 30, 2002 were $5.1 million.

     As of September 30, 2002, the Company owned marketable equity securities of a Japanese company, representing approximately 14% of the investee’s outstanding shares, accounted for as available-for-sale securities. The market value of these shares has increased from the Company’s original cost resulting in a carrying value at September 30, 2002 of $17.3 million. The increase over the Company’s cost basis, net of tax effects, is reflected as a component of accumulated other comprehensive income (loss). During the nine months ended September 30, 2002, the Company sold a portion of its holdings recognizing a gain of $2.4 million which was reclassified from accumulated other comprehensive income (loss) to net loss. Excluding the effect of this sale, the fair value of the Company’s investment declined by $54.6 million during the nine months ended September 30, 2002. This decline is reflected as a component of other comprehensive loss. The market for the investee’s shares is relatively limited, the share price is volatile and the investment is strategic in nature. Accordingly, there can be no assurance that a gain can be realized through the disposition of these shares.

NOTE 5 — INVESTMENT IN MUSICNET

     In 2001, the Company announced the formation of MusicNet, Inc. (MusicNet), a venture with four media companies to create a platform for online music subscription services. MusicNet, which previously was a subsidiary of the Company, issued additional shares of

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capital stock in April and July 2001 reducing the Company’s ownership interest. The Company’s investment in MusicNet is accounted for under the equity method of accounting. As a result, the Company records in its statement of operations its equity share in MusicNet’s net income (loss) which was a loss of $1.6 million and $5.1 million for the quarter and nine months ended September 30, 2002, respectively. In July 2002, the Company and the other investors contributed additional capital to MusicNet to fund its business. The Company received a convertible note, convertible into additional shares of MusicNet capital stock, in exchange for its additional investment. The Company anticipates that MusicNet will continue to incur losses in the foreseeable future and will require additional funding to support the development of its business model. Based on the nature and terms of the convertible note, in the quarter ended September 30, 2002, for purposes of calculating the Company’s equity in net loss of MusicNet, the convertible note was treated on an “as if” converted basis. For the quarter ended September 30, 2002, the loss of $1.6 million recorded by the Company represents 36.8% of MusicNet’s quarterly loss. As of September 30, 2002, the Company’s ownership interest in MusicNet was approximately 28.6% and the carrying value for its investment was $6.4 million. In the quarter and nine months ended September 30, 2002, the Company recognized approximately $315,000 and $1,053,000, respectively, of revenue related to agreements with MusicNet and was reimbursed $0 and $124,000 for the quarter and nine months ended September 30, 2002, respectively, for certain administrative services provided to MusicNet on a transitional basis, which has been accounted for as a reduction of related expenses.

NOTE 6 — LOSS ON EXCESS OFFICE FACILITIES

     In October 2000, the Company entered into a 10-year lease agreement for additional office space located near its corporate headquarters in Seattle, Washington. During 2001, the Company re-evaluated its facilities requirements and, as a result, decided to permanently sublet all of this office space. The market for office space in Seattle has significantly declined from the date the Company entered into this lease. As a result, the Company recorded losses of $5.6 million and $22.2 million during the quarter and nine months ended September 30, 2001, respectively. For the nine months ended September 30, 2001, these losses represented approximately $15.2 million of rent and operating expenses over the remaining life of the lease, net of expected sublease income and approximately $7.0 million for the write-down of leasehold improvements to their estimated fair value. The Company’s estimates are based upon many factors including projections of sublease rates and the time period required to locate tenants. During the quarter ended September 30, 2002, the Seattle real estate market continued to display significant weakness, which is reflected in both increasing vacancy rates and declining rental rates. Based on discussions with prospective tenants, the Company concluded that the excess office facilities are not likely to be sublet at rates used in the original loss estimates. As a result, the Company recorded additional losses of $17.2 million during the quarter and nine months ended September 30, 2002. The Company regularly evaluates the market for office space in Seattle. If the market for such space declines further in future periods, the Company may have to revise its estimates which may result in additional losses on excess office facilities.

     A summary of activity for the accrued loss on excess office facilities is as follows (in thousands):

NOTE 7 — PERSONNEL REDUCTION, RESTRUCTURING, AND RELATED CHARGES

     In August 2002, the Company implemented a restructuring plan to reduce costs, which included reducing its staffing levels by approximately 10%, closing selected offices, and canceling its annual user conference. The Company recorded a charge of approximately $3.6 million during the quarter ended September 30, 2002 to reflect costs associated with implementing this plan. These costs were primarily related to severance payments, but also included other miscellaneous costs such as professional fees, outplacement services for terminated employees, office closures, and tradeshow deposit forfeitures, all of which were incurred as of September 30, 2002. The Company expects payments for restructuring costs to be completed in 2003. In July 2001, the Company reduced its staffing levels by approximately 15%. The Company recorded a charge of approximately $3.9 million during the quarter ended September 30, 2001 to reflect costs associated with implementing the staff reduction.

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     A summary of activity for the 2002 personnel reduction, restructuring, and related charges is as follows (in thousands):

							Professional				Office				Tradeshow
			Severance				Services				Closures				Deposits				Total
Accrued amount at December 31, 2001, related to previous staff reduction charges			$	—				295				—				—				295
	August 2002 restructuring plan			1,721				395				966				513				3,595
	Less amounts paid			(1,621	)			(588	)			(118	)			(419	)			(2,746	)
Accrued amount at September 30, 2002			$	100				102				848				94				1,144

NOTE 8 — REPURCHASE OF COMMON STOCK

     The Company’s Board of Directors authorized the repurchase of up to an aggregate of $50 million of the Company’s outstanding common stock. Any purchases of common stock under the share repurchase program will be made from time-to-time, in the open market, through block trades or otherwise. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time without prior notice. During the nine months ended September 30, 2002, the Company repurchased approximately 4.3 million shares at an average cost of $4.77 per share for a total of $20.4 million. Since the program’s inception, the Company has repurchased approximately 6.7 million shares at an average cost of $4.95 per share for a total of $33.2 million.

NOTE 9 — LITIGATION

     In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against the Company and co-defendant Broadcast.com in the United States District Court for the Northern District of Texas — Dallas Division. The plaintiffs allege that the Company, individually and in combination with Broadcast.com, infringes on a certain patent by making, using, selling and/or offering to sell software products and services directed to media delivery systems for the Internet and corporate intranets. The plaintiffs seek to enjoin the Company from the alleged infringing activity and to recover damages in an amount no less than a reasonable royalty. The Company may be required to indemnify Broadcast.com under the terms of its license agreement. The plaintiffs filed a similar claim based on the same patent and seeking similar remedies as a separate lawsuit against Microsoft and Broadcast.com in the same court. The court has consolidated the lawsuit against Microsoft and Broadcast.com with the lawsuit against the Company and Broadcast.com. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other royalties, in addition to complying with injunctive relief, which could have a material adverse effect on the Company’s operating results. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit, and intends to vigorously defend itself against these claims. Accordingly, no amounts have been accrued for this matter at September 30, 2002. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations.

     Between November 1999 and March 2000, fourteen lawsuits were filed against the Company in federal and/or state courts in California, Illinois, Pennsylvania, Texas and Washington. The plaintiffs have voluntarily dismissed all of the state court cases with the exception of the case pending in California. The remaining actions, which seek to certify classes of plaintiffs, allege breach of contract, invasion of privacy, deceptive trade practices, negligence, fraud and violation of certain federal and state laws in connection with various communications features of the Company’s RealPlayer and RealJukebox products. Plaintiffs are seeking both damages and injunctive relief. The Company has filed answers denying the claims and has filed suit in Washington State Court to compel the state court plaintiffs to arbitrate the claims as required by the Company’s End User License Agreements. The Washington State Court has granted the Company’s motion to compel arbitration. However, the California trial court has entered an order stating that it is not bound by the Washington court’s decision. That order is currently under review by the California Court of Appeal. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day, that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under RealNetworks’ End User License Agreement. Although no assurance can be

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given as to the outcome of these lawsuits, the Company believes that the allegations in these actions are without merit, and intends to vigorously defend itself. Accordingly, no amounts have been accrued for this matter as of September 30, 2002. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.

     From time to time RealNetworks is, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including employment claims, contract-related claims and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. These claims, even if not meritorious, could force the Company to spend significant financial and managerial resources. The Company currently has a number of such claims threatened against it relating to intellectual property infringement or employment, though it believes these claims are without merit. In July 2002, a lawsuit was filed against the Company in federal court in Boston alleging that the Company willfully infringes certain patents relating to “the downloading of data from a server computer to a client computer.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble damages arising from the alleged infringement. The Company has filed a counterclaim against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as its reasonable attorneys fees and costs. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the plaintiff’s allegations in this action are without merit and intends to vigorously defend itself against these claims. The Company is not aware of any legal proceedings or claims that the Company believes will have, individually or taken together, a material adverse effect on the Company’s business, prospects, financial condition or results of operations. However, the Company may incur substantial expenses in defending against third party claims. In the event of a determination adverse to the Company, the Company may incur substantial monetary liability, and/or be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position and results of operations.

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

     The discussion in this report contains forward-looking statements that involve risks and uncertainties. We have identified a number of these forward-looking statements in the section below entitled “Special Note Regarding Forward-Looking Statements.” RealNetworks’ actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Factors that May Affect Our Business, Future Operating Results and Financial Condition”, included elsewhere in this Report. You should also carefully review the risk factors set forth in other reports or documents that RealNetworks files from time to time with the Securities and Exchange Commission, particularly our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

OVERVIEW

     RealNetworks is a leading global provider of software products and services for Internet media delivery. We develop and market software products and services designed to enable users of personal computers and other consumer electronic devices to send and receive audio, video and other multimedia services using the World Wide Web.

     We were incorporated in February 1994 and were in the development stage until July 1995, when we released the commercial version of RealAudio Version 1.0, the first version of our RealPlayer products. In August 1996, we began selling RealPlayer Plus, a premium version of our RealPlayer product. Since its initial release, RealPlayer has been available for download free of charge from our websites. In December 1997, we released the commercial version of RealSystem Version 5.0, a streaming media solution that included RealAudio and RealVideo technology. In September 1999, we released the commercial versions of RealJukebox and RealJukebox Plus, a personal music management system. In August 2000, we released the gold version of RealPlayer 8, RealJukebox 2 and launched RealPlayer GoldPass, a for-pay media subscription service available to RealPlayer Plus customers. In March 2001, we introduced RealArcade, a new end-to-end platform for the digital distribution of PC games benefiting both developers and consumers. In June 2001, we launched RealSystem Media Commerce Suite, a platform for Internet media commerce that is intended to provide a universal platform for secure distribution of digital movies, music, and other content. In December 2001, we launched our RealOne subscription service which incorporates our RealPlayer and RealJukebox products together with a new media browser and value-added services to create a multi-dimensional media experience for consumers. In June 2002, we launched RealOne Europe, a European edition of our RealOne subscription service. In July 2002, we launched Helix, an open, comprehensive Internet media delivery platform and community to enable creation of digital media products and applications for any format, operating system or device. In September 2002, we launched RealOne Player Version 2.0.

     We report revenues in three categories:

-		Software license fees, which include revenues from sales of our RealPlayer Plus and RealJukebox Plus and other related products, and sales of our media delivery system software, including RealServers and Helix system software, and related authoring and publishing tools, both directly to customers and indirectly through OEM channels, and sales of third-party products, including games.
-		Service revenues, which include revenues from RealPlayer GoldPass/RealOne subscription services, including our RealOne Music subscription service, support and maintenance services that we sell to customers who purchase our RealPlayer Plus and RealJukebox Plus and other related products, and who purchase our media delivery system software including RealServers and Helix system software, and related authoring and publishing tools, broadcast hosting services we provide through our Real Broadcast Network and consulting services we offer to our customers.
-		Advertising revenues, which are derived from sales of advertising on our Web sites and client software and within the media streams that we host on behalf of our corporate customers.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

     Our critical accounting policies and estimates are as follows:

	•		Revenue recognition
	•		Estimating sales returns and the allowance for doubtful accounts
	•		Estimating losses on excess office facilities

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	•		Determining whether declines in the fair value of investments are other-than-temporary and estimating fair market value of investments in privately held companies
	•		Valuation of goodwill
	•		Valuation of deferred income tax assets

     Revenue Recognition

     As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates.

     We recognize revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.” Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software.

     For all sales, except those completed via credit card transactions through the Internet, we use either a binding purchase order or signed agreement, depending on the nature of the transaction, as evidence of an arrangement. For sales made via the Internet, we use the customer’s authorization to charge their credit card as evidence of an arrangement. Sales through our distributors are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction by transaction basis.

     For software license fees in single element arrangements and multiple element arrangements which do not include customization or consulting services, delivery typically occurs when the product is made available to the customer for download or when products are shipped to customers. For service and advertising revenues, delivery typically occurs when services have been performed.

     At the time of each transaction, we assess whether the fee associated with our revenue transactions is fixed and determinable and whether or not collection is reasonably assured. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of a fee is due after our normal payment terms, is based upon a variable matrix such as a minimum level of distribution or is subject to refund, we account for the fee as not being fixed and determinable. In these cases, we defer revenue and recognize it when it becomes due and payable.

     We assess the probability of collection based on a number of factors, including past transaction history and the current financial condition of the customer. We do not request collateral from our customers but often require payments before or at the time products and services are delivered. If we determine that collection of a fee is not reasonably assured, we defer revenue until the time collection becomes reasonably assured, which is generally upon receipt of cash.

     For multiple element arrangements, when company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, we recognize revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, we defer revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognize the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. Company-specific objective evidence is established for support and upgrades of standard products for which no installation or customization is required based upon the amounts we charge when support and upgrades are sold separately. Company-specific objective evidence is established for consulting and installation services based on the hourly rates we charge for our employees when they are performing these services provided we have the ability to accurately estimate the hours required to complete a project based upon our experience with similar projects. For multiple element arrangements involving installation or customization, company-specific objective evidence is established for support and maintenance arrangements if our customers have an optional annual renewal rate specified in the arrangement and the rate is substantive.

     If specific objective evidence of fair value does not exist for an undelivered element in a software arrangement, which, for us, typically relates to the development of

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complex content delivery networks which include software licenses, consulting services and product support, revenue is recognized over the term of the support period commencing upon delivery of our technology to the customer. In these cases, delivery is defined as when the content delivery network is installed and operating in accordance with contract specifications.

     Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating our software to the end user. In the case of prepayments received from an OEM, we typically recognize revenue based on the actual products sold by the OEM. If we provide ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue is recognized ratably over the term of the contract.

     Service revenues include payments under GoldPass/RealOne and standalone media subscription services, support and upgrade contracts and fees from consulting services and streaming media content hosting. Media subscription service revenues are recognized ratably over the period that services are provided. Support and upgrade revenues are recognized ratably over the term of the contract, which typically is twelve months. Other service revenues are recognized when the services are performed.

     Fees generated from advertising are recognized as advertising is delivered over the terms of the contracts. We may guarantee a minimum number of advertising impressions, click-throughs or other criteria on our Web sites or products for a specified period. To the extent these guarantees are not met, we defer recognition of the corresponding revenues until guaranteed delivery levels are achieved.

     Sales Returns and the Allowance for Doubtful Accounts

     The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Specifically, we must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances. Significant judgments and estimates must be made and used in connection with establishing reserves for sales returns and the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we made different judgments or utilized different estimates. Similarly, we must make estimates of the uncollectibility of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

     Loss on Excess Office Facilities

     We have made significant estimates in determining the appropriate amount of accrued loss on excess office facilities. If we made different estimates, our loss on excess office facilities would be significantly different from that recorded, which could have a material impact on our operating results. We have revised our original estimate twice in the last five quarters. The significant factors we considered in making our estimates are discussed in the following pages under “Loss on Excess Office Facilities.”