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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

For the quarterly period ended September 27, 2003.

Or

For the transition period from                      to                     

Commission File Number: 0-26976

Pixar

(510) 752-3000
(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 o

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No o

     The number of shares outstanding of the registrant’s Common Stock as of November 3, 2003 was 55,275,493.

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Pixar
FORM 10-Q
Index

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

PIXAR

BALANCE SHEETS

See accompanying notes to financial statements.

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PIXAR

STATEMENTS OF INCOME

See accompanying notes to financial statements.

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PIXAR

STATEMENTS OF CASH FLOWS

See accompanying notes to financial statements.

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PIXAR

NOTES TO FINANCIAL STATEMENTS

(1) Basis of Presentation

     The accompanying unaudited condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the financial condition, results of operations, and cash flows of Pixar (or the “Company”) for the periods presented. These financial statements should be read in conjunction with the audited financial statements as of December 28, 2002 and for each of the years in the three-year period ended December 28, 2002, including notes thereto, which are included in Pixar’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

     The results of operations for the quarter and nine month periods ended September 27, 2003 are not necessarily indicative of the results to be expected for the entire year.

     Certain amounts reported in previous periods have been reclassified to conform to the 2003 financial statement presentation.

(2) Fiscal Year

     Pixar operates on a 52- or 53-week fiscal year, whereby the year ends on the Saturday nearest December 31. Fiscal year 2003 will end on January 3, 2004 and will consist of 53 weeks.

(3) Stock Option Accounting

     The Company has elected to continue using the intrinsic-value method of accounting for stock-based compensation plans in accordance with Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company has adopted those provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which require disclosure of the pro forma effects on net income and net income per share as if compensation cost had been recognized based upon the fair value-based method at the date of grant of options awarded.

     The following table reflects pro forma net income and net income per share had the Company elected to adopt the fair value-based method (in thousands, except per share data):

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     These pro forma amounts may not be representative of future disclosures since the estimated fair value of stock options is amortized to expense over the vesting period, and additional options may be granted in future years. The pro forma amounts assume that the Company had been following the fair value-based method since the beginning of 1996.

     The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The weighted-average fair value of options granted was $31.19 and $25.89 for the quarter and nine months ended September 27, 2003, respectively, and $20.72 and $17.34 for the quarter and nine months ended September 28, 2002, respectively. Values were estimated using zero dividend yield for all years; expected volatility of 50% and 51% for the quarter and nine months ended September 27, 2003, respectively, and 52% for the corresponding prior year periods; risk-free interest rates of 3.31% and 2.95% for the quarter and nine months ended September 27, 2003, respectively, and 3.03% and 4.21% for the corresponding prior year periods; and weighted-average expected lives for all periods of 5.0 years.

(4) Net Income per Share

     Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common and dilutive potential common shares outstanding during the period, using the treasury stock method for options. Of the outstanding options to purchase shares of common stock, for the quarter and nine months ended September 27, 2003, options to purchase approximately 6,000 shares and 85,000 shares, respectively, of common stock were not included in the computation of diluted net income per share because the options’ exercise price was greater than the average market price of the common shares. Options to purchase approximately 52,000 shares and 382,000 shares, respectively, of common stock were excluded for the quarter and nine months ended September 28, 2002.

     The reconciliation of basic and diluted net income per share is as follows (in thousands, except per share amounts):

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(5) Comprehensive Income

     Other comprehensive income consists of unrealized holding gains or losses on the Company’s investments. The following table sets forth the calculation of comprehensive income, net of income taxes (in thousands):

(6) Feature Film and Co-Production Agreements

Feature Film Agreement

     In 1991, the Company entered into a feature film agreement with Walt Disney Pictures, a wholly owned subsidiary of Walt Disney Pictures and Television (together with its subsidiaries and affiliates collectively referred to herein as “Disney”), to develop and produce up to three computer-animated feature films (the “Feature Film Agreement”). The Company is entitled to receive compensation based on revenue from the distribution of these films and related products. In 1995, the Company released its first feature film under the terms of the Feature Film Agreement, Toy Story. Based on the individual-film-forecast-computation method, all significant Toy Story film production costs were fully amortized by the year ended December 31, 1997.

Co-Production Agreement

     In February 1997, Pixar and Disney entered into a Co-Production Agreement (the “Co-Production Agreement”) which governs all films made by the Company since Toy Story. Under the Co-Production Agreement, Pixar, on an exclusive basis, agreed to produce five original computer-animated theatrical motion pictures (the “Pictures”) for distribution by Disney. Pixar and Disney co-own, co-brand and co-finance the production costs of the Pictures, and share equally in the profits of each Picture and any related merchandise and other ancillary products, after recovery of all of Disney’s marketing, distribution and other predefined fees and costs. The Co-Production Agreement generally provides that Pixar is responsible for the production of each Picture, and Disney is responsible for the marketing, promotion, publicity, advertising and distribution of each Picture. The first three original films produced under the Co-Production Agreement were A Bug’s Life, Monsters, Inc., and Finding Nemo. Films currently in production at Pixar that are governed by this agreement include The Incredibles and Cars. A Bug’s Life, Monsters, Inc., Finding Nemo, The Incredibles, and Cars count toward the five original Pictures, whereas Toy Story 2, as a sequel, is a derivative work that does not count toward the Pictures. Under the Co-Production Agreement, all provisions applicable to the Pictures also apply to derivative works such as Toy Story 2.

     All payments to Pixar from Disney for development and production of Toy Story under the Feature Film Agreement, and A Bug’s Life, Toy Story 2, Monsters, Inc., Finding Nemo, The Incredibles, and Cars under the Co-Production Agreement have been recorded as cost reimbursements. Accordingly, no revenue has been recognized for such reimbursements; rather, the Company has netted the reimbursements against the related costs.

Creative Group

     In addition to the films produced and in process under the Co-Production Agreement, Pixar’s creative development group is working on concept development and pre-production for several new projects that are not governed by the Co-Production Agreement. Costs related to these projects, for example, the first feature film produced outside the existing Disney relationship (“Project 2006”), are therefore neither shared nor reimbursed by Disney. Such costs are capitalized as film costs and will be amortized under the individual-film-forecast-computation method. In the event a film is not set for production within three years from the time of the first

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capitalized transaction, all such costs would be expensed. Project 2006 was approved for production in February 2003 and is currently targeted for a 2006 release.

Components of Capitalized Film Production Costs

     The total film production costs and related amounts capitalized are as follows (in thousands):

(1)

In the second quarter of 2003, the Company wrote-off $1.9 million in costs previously capitalized for future film projects, which the Company determined would not be green-lighted for production within three years following their initial cost capitalization.

     Under the Co-Production Agreement, certain operating expenses benefiting the productions, such as certain research and development and certain general and administrative expenses, are paid half by Pixar and half by Disney. From the beginning of each respective fiscal year, the Company recorded the following amounts reimbursed by Disney as offsets to the following expense categories (in thousands):

     For released films, the Company expects to amortize, based on current estimates, approximately $37 million to $41 million in capitalized film production costs over the succeeding twelve-month period. In addition, the Company has amortized more than 80% of each released film’s original production costs as of September 27, 2003, with the exception of Finding Nemo, which is projected to reach the 80% milestone in the second half of fiscal 2004.

     At September 27, 2003 and December 28, 2002, receivables from Disney aggregated $48.9 million and $129.3 million, respectively, which consists of receivables for film revenue, advances net of Disney’s actual share of production expenditures for all films under the Co-Production Agreement and amounts due for miscellaneous reimbursements.

(7) Segment Reporting

     The chief operating decision-maker is considered to be the Company’s Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a summary basis accompanied by disaggregated information about film revenue for purposes of making operating decisions and assessing financial performance. The summary financial information reviewed by the CEO is identical to the information presented in the accompanying statement of income, and the Company has no foreign operations. Therefore, the Company operates in a single operating segment.

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     The Company’s revenue segment information by film category follows (in thousands):

(1)		During the quarter ended September 27, 2003, the Company received a settlement on Monsters, Inc. merchandise revenue which resulted in an increase in film revenue of $3.5 million and $0.03 to diluted net income per share.
(2)		During the quarter ended June 28, 2003, the Company recognized an adjustment, which reduced revenues for Monsters, Inc. domestic home video after the Company received updated information from Disney which reflected higher returns of domestic home video than had been originally anticipated. This adjustment reduced home video revenues by $4.4 million and had a net impact of $0.04 to diluted net income per share.
(3)		Library titles include Toy Story, A Bug’s Life and Toy Story 2. For the quarter and nine months ended September 28, 2002, Toy Story 2 revenues of $11.3 million and $20.0 million, respectively, have been reclassified to “Library titles” to conform to the current year presentation.
(4)		During the quarter ended September 28, 2002, certain adjustments were made to previous estimates for return reserves and expenses. These adjustments increased home video and merchandise net revenues for Toy Story 2 and A Bug’s Life and contributed approximately $0.14 to the Company’s third quarter 2002 diluted net income per share.

(8) Related Party Transaction

     In June 2003, the Company entered into an agreement to reimburse its CEO for expenses incurred by him in the operation of his private plane when used for Pixar business. For the nine months ended September 27, 2003, the Company incurred a total of approximately $91,000 of such expenses.

(9) New Accounting Pronouncements

     In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (SFAS 143). SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS 143 applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development or normal use of the asset. As used in this Statement, a legal obligation results from existing law, statute, ordinance, written or oral contract, or by legal construction of a contract under the doctrine of promissory estoppel. SFAS 143 is effective for fiscal years beginning after June 15, 2002. The adoption of SFAS 143 has not had an impact on the Company’s financial position or results of operations.

     In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146). SFAS 146 requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability has been incurred. The Company adopted SFAS 146 effective with the beginning of fiscal 2003. The adoption of SFAS 146 has not had an impact on the Company’s financial position or results of operations.

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     In January 2003, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of FASB Statements No. 5, 57 and 107 and a Recision of FASB Interpretation No. 34” (FIN 45). FIN 45 clarifies the requirements for a guarantor’s accounting for and disclosure of certain guarantees issued and outstanding in interim and annual financial statements. FIN 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, the liability for the fair value of the obligation undertaken. The disclosure requirements are effective for financial statements of interim and annual periods after December 31, 2002. The initial recognition and initial measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002. The Company adopted the provisions of FIN 45 effective with the beginning of fiscal 2003. The adoption of FIN 45 has not had a material impact on the Company’s financial statements or results of operations.

     In November 2002, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 00-21, “Accounting for Revenue Arrangement with Multiple Deliverables,” which addresses circumstances involving the delivery or performance of multiple products, services, and/or rights to use assets, and for which performance may occur at different points in time or over different periods of time. Issue No. 00-21 also addresses whether the different revenue-generating activities, or deliverables, are sufficiently separable, and there exists sufficient evidence of their fair values to separately account for some or all of the deliverables. The issue applies to all contractual arrangements under which a vendor will perform multiple revenue-generating activities. Issue No. 00-21 is effective for all revenue arrangements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. The Company adopted Issue No. 00-21 effective the beginning of fiscal 2003. The adoption of Issue No. 00-21 has not had a material impact on the Company’s financial statements or results of operations.

     In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” that amends SFAS No. 123, “Accounting for Stock-Based Compensation.” The standard provides for (1) alternative methods of transition for an entity that voluntarily changes to the fair-value method of accounting for stock-based employee compensation, (2) requires more prominent disclosure of the effects of an entity’s accounting policy decisions with respect to stock-based employee compensation on reported income, and (3) amends APB Opinion No. 28, “Interim Financial Reporting,” to require disclosure of those effects in interim financial information. SFAS No. 148 is effective for fiscal years ending after December 15, 2002 and for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. The Company continues to account for employee stock options using the intrinsic value method in accordance with APB Opinion No. 25 and has adopted the additional disclosure requirements of SFAS No. 148.

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

     This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995, particularly statements referencing the targeted release dates of our feature films, our revenue expectations for the fourth quarter of fiscal 2003, our target earnings per share for the full year of fiscal 2003, our anticipated revenues and operating expenses and our expectations regarding any future distribution arrangement we may enter into. Such forward-looking statements are based on current expectations, estimates and projections about our industry, management’s beliefs, and assumptions made by management. In some cases, forward-looking statements can be identified by the use of words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “is scheduled for,” “targeted,” variations of such words and similar expressions. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict; therefore, actual results and outcomes may differ materially from what is expressed or forecasted in any such forward-looking statements. Such risks and uncertainties include those set forth herein under “Risk Factors” on pages 17 through 32. Particular attention should be paid to the cautionary language in Risk Factors “- To meet our fiscal 2003 earnings projections, we are dependent on our feature films and the accuracy of our forecasts,” “- Our operating results have fluctuated in the past, and we expect such fluctuations to continue,” “- Our scheduled successive releases of feature films will continue to place a significant strain on our resources,” and “- The Co-Production Agreement imposes several risks and restrictions on us.” Unless required by law, Pixar undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

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     The following discussion should be read in conjunction with the section entitled “Risk Factors” on pages 17 through 32 below and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 28, 2002 in addition to our interim financial statements and notes included elsewhere in this report.

Overview

     Pixar was formed in 1986 when Steve Jobs purchased the computer division of Lucasfilm and incorporated it as a separate company. In 1991, we entered into a feature film agreement (the “Feature Film Agreement”) with Walt Disney Pictures, a wholly owned subsidiary of the Walt Disney Company (together with its subsidiaries and affiliates collectively referred to herein as “Disney”), for the development and production of up to three animated feature films to be marketed and distributed by Disney. Our share of revenues and expenses from Toy Story, our first feature film, was governed by the terms of the Feature Film Agreement.

     In February 1997, we entered into the Co-Production Agreement (which superseded the Feature Film Agreement) with Disney pursuant to which we, on an exclusive basis, agreed to produce five original computer-animated feature-length theatrical motion pictures (the “Pictures”) for distribution by Disney. Pixar and Disney agreed to co-finance the production costs of the Pictures, co-own the Pictures (with Disney having exclusive distribution and exploitation rights), co-brand the Pictures, and share equally in the profits of each Picture and any related merchandise as well as other ancillary products, after recovery of all marketing and distribution costs (which Disney finances), a distribution fee paid to Disney and any other fees or costs, including any participations provided to talent and the like. The Co-Production Agreement generally provides that we will be responsible for the production of each Picture, while Disney will be responsible for the marketing, promotion, publicity, advertising and distribution of each Picture.

     The Co-Production Agreement also contemplates that with respect to theatrical sequels, made-for-home video sequels, television productions, interactive media products and other derivative works related to the Pictures, we will have the opportunity to co-finance and produce such products or to earn passive royalties on such products. We do not share in any theme park revenues generated as a result of the Pictures. Pursuant to the Co-Production Agreement, in addition to co-financing the production costs of the Pictures, Disney will reimburse us for our share of certain general and administrative costs and certain research and development costs that benefit the productions.

     Our second feature film, A Bug’s Life, was released in November 1998 and counts as the first Picture under the Co-Production Agreement. In November 1999, Toy Story 2, our third animated feature film was released. As a theatrical sequel, Toy Story 2 is a derivative work of the original Toy Story, and therefore it does not count toward the Pictures to be produced under the Co-Production Agreement. However, as a derivative work, Toy Story 2 is treated for all other purposes as a Picture under the Co-Production Agreement, and all the provisions applicable to the Pictures apply.

     In November 2001, we released Monsters, Inc., our fourth animated feature film, which counts as the second Picture under the Co-Production Agreement. On May 30, 2003, we released Finding Nemo, our third Picture under the Co-Production Agreement. We are currently in various stages of production on the final two films under the Co-Production Agreement, The Incredibles and Cars. These films will count as the fourth and fifth films of the Pictures to be produced under the Co-Production Agreement. The Incredibles is currently targeted for release on November 5, 2004, and Cars is currently targeted for a holiday release in 2005.

     All payments to us from Disney for development and production of Toy Story under the Feature Film Agreement, and A Bug’s Life, Toy Story 2, Monsters, Inc., Finding Nemo, The Incredibles, and Cars, under the Co-Production Agreement have been recorded as cost reimbursements. Accordingly, no revenue has been recognized for such reimbursements; rather, we have netted the reimbursements against the related costs.

     The statements regarding the targeted release dates for our future films are forward-looking, and the actual release dates may differ. Factors that could cause delays in the release of our films include, but are not limited to: (1) the uncertainties related to production delays, (2) financing requirements, (3) personnel availability, (4) external socioeconomic and political events, and (5) the release dates of competitive films. Please see “Risk Factors” on pages 17 through 32 for a more detailed discussion of these factors.

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Target Earnings per Share for Fiscal 2003

     During the fourth quarter, we believe revenues will be largely comprised of Finding Nemo’s domestic home video sales and international box office receipts from certain European territories and Japan. We expect Finding Nemo home video sales will exceed those of Monsters, Inc. over its lifetime. Consequently, our projections assume approximately 22 to 24 million units of the Finding Nemo home video will be sold in the U.S. during the fourth quarter of fiscal 2003. Our projections also assume that Finding Nemo will achieve $400 million at the international box office; however, we estimate that only $300 million of that will be recognized in fiscal 2003. In addition, we expect to recognize the majority of all remaining marketing and distribution costs related to its worldwide home video release as well as its remaining international theatrical releases during the fourth quarter of fiscal 2003. Our projections also assume ongoing merchandise revenues and ancillary royalties from Finding Nemo. We also assume that we will recognize merchandise revenues, ongoing home video sales, international television licensing and ancillary royalties relating to the sale of products from Monsters, Inc., as well as some revenues from our library titles throughout the remainder of the year. Our assumptions for fiscal 2003 also include continued software sales, interest income, operating expenses and an effective tax rate of approximately 40%.

     Based on Finding Nemo’s success at the domestic box office, our expectation of its international box office run exceeding the domestic box office, and a successful domestic home video release, we are estimating diluted earnings per share guidance for fiscal 2003 of approximately $1.76.

     These statements regarding our targeted earnings per share and the underlying assumptions are forward-looking, and actual results may differ materially. These forward-looking statements should not be relied upon as representing Pixar’s view as of any subsequent date, and Pixar undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the date they were made. Factors that could cause actual results for fiscal year 2003 to differ include, but are not limited to: (1) the timing and amount of worldwide revenues and distribution costs from Finding Nemo, Monsters, Inc. and other titles in our film library, (2) the timing, accuracy, and sufficiency of the information we receive from Disney to determine revenues and associated gross profits, (3) the timing and amount of non-film related revenues and expenses, (4) the accuracy of assumptions and judgments used to estimate certain revenues and associated gross profits, (5) the market price of our Common Stock and related volatility and (6) external socioeconomic and political events that are beyond our control. Please see “Risk Factors” for a more detailed discussion of these factors.

Critical Accounting Policies

Revenue Recognition

     We recognize film revenue from the distribution of our animated feature films and related products when earned and reasonably estimable in accordance with Statement of Position 00-2 — “Accounting by Producers or Distributors of Films” (SOP 00-2). The following are the conditions that must be met in order to recognize revenue in accordance with SOP 00-2:

•		persuasive evidence of a sale or licensing arrangement with a customer exists;
•		the film is complete and, in accordance with the terms of the arrangement, has been delivered or is available for immediate and unconditional delivery;
•		the license period of the arrangement has begun and the customer can begin its exploitation, exhibition or sale;
•		the arrangement fee is fixed or determinable; and
•		collection of the arrangement fee is reasonably assured.

     Under the Co-Production Agreement, we share equally with Disney in the profits of the Pictures after Disney recovers its marketing, distribution and other predefined costs and fees. Our revenues for Toy Story are governed by the terms of the Feature Film Agreement. Although our revenues are based on the information we receive from Disney, we may make adjustments to that information based on our estimates and judgments. For example, our

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theatrical revenues may be adjusted for our estimated reserves on potential uncollectible amounts to be received from theatrical exhibitors. We also make adjustments to our home video revenues for estimates on return reserves that may differ from those reported by Disney. The estimates on reserves may be adjusted periodically based on actual rates of returns, inventory levels in the distribution channel, as well as other business and industry information. In addition, we utilize margin normalization, such as with merchandising or home video, in accordance with the provisions of SOP 00-2. This may result in the utilization of budgeted or forecasted information rather than actual costs incurred if it is deemed to be a more accurate reflection of our participation. Similar to return reserves, these expense estimates are reviewed and may be adjusted periodically to ensure the most accurate depiction of our participation is reflected. Such adjustments were made to home video reserve and home video and merchandise expense estimates during fiscal 2002 and 2003. During fiscal 2002, one-time adjustments to A Bug’s Life and Toy Story 2 home video reserves and margins and merchandising revenues had a positive net impact of $0.19 to our diluted net income per share. During the second quarter of fiscal 2003, we recognized an adjustment which reduced our Monsters, Inc. domestic home video revenue after we received updated information from Disney which reflected higher returns of domestic home video than had been originally anticipated. This adjustment reduced our home video revenues by $4.4 million and had a net impact of $0.04 to our diluted net income per share.

     The amount of revenue recognized in any given quarter or quarters from all of our films depends on the timing, accuracy and sufficiency of the information we receive from Disney to determine revenues and associated gross profits. Although Disney provides us with the most current information available to enable us to recognize our share of revenue and determine our film gross profit, Disney may also make subsequent adjustments to the information that it has provided, and these adjustments could have a material impact on our operating results in later periods. As updated information becomes available from Disney on a more timely basis, it may result in a change of estimation for revenue recognition. For example, we received a settlement on Monsters, Inc. merchandise revenue for the third quarter ended September 27, 2003, which resulted in an increase of $3.5 million to our revenues and $0.03 to our diluted net income per share. We also received updated information from Disney in the first quarter of fiscal 2003, which decreased previously recorded home video expenses by $3.2 million for all of our film titles on a cumulative basis. This resulted in an increase of $0.03 to our diluted net income per share for our first quarter of fiscal 2003. Additionally, we have the right to audit Disney’s books and records related to the Pictures according to the terms of the Co-Production Agreement, which could result in adjustments that may be material to the financial statements in any given quarter or quarters. Any revenue received in advance from Disney is deferred and recorded as revenue when earned.

     In accordance with the provisions of SOP 00-2, a film is classified as a library title after three years from the film’s initial release. Currently, Toy Story, A Bug’s Life and Toy Story 2 are classified as library titles. The term library titles is used solely for the purpose of classification and for identifying previously released films in accordance with the provisions of SOP 00-2. Revenue recognition for such titles is in accordance with our revenue recognition policy for film revenue.

     Film Production Costs

     We capitalize our share of direct film production costs in accordance with SOP 00-2. Film production costs include costs to develop and produce computer animated motion pictures, which primarily consists of salaries, equipment and overhead. Film production costs in excess of reimbursable amounts from Disney are capitalized. Production overhead, a component of film costs, includes allocable costs of individuals or departments with exclusive or significant responsibility for the production of our films. Capitalized production overhead does not include administrative, general and research and development expenses. In addition to the films produced, we are also working on concept development for several new projects.

     Once a film is released, capitalized film production costs are amortized in the proportion that the revenue during the period for each film bears to the estimated revenue to be received from all sources under the individual-film-forecast-computation method. The amount of film costs that will be amortized each quarter will depend on how much future revenue we expect to receive from each film. We make certain estimates and judgments of our future gross revenues to be received for each film based on information received from Disney and our knowledge of the industry. Estimates of anticipated total gross revenues are reviewed periodically and may be revised if necessary. A change to the estimate of gross revenues for an individual film may result in an increase or decrease to the percentage of amortization of capitalized film costs relative to a previous period. Unamortized film production costs

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are compared with net realizable value each reporting period on a film-by-film basis. If estimated remaining gross revenues are not sufficient to recover the unamortized film production costs, the unamortized film production costs would be written down to fair value.

Results of Operations

     Our results for the quarter and nine months ended September 27, 2003 were driven primarily by Finding Nemo’s worldwide box office revenues, merchandise sales and ancillary royalties. Also contributing to our results were revenues associated with Monsters, Inc. and our library titles.

Revenue

     Total revenue, which consists of film revenue and software revenue, was $30.2 million and $97.7 million for the quarter and nine months ended September 27, 2003, respectively, compared to $102.5 million and $162.3 million in the corresponding prior year periods.

     Film revenue for the quarter ended September 27, 2003 was $27.5 million compared with $100.5 million in the corresponding prior year period. Higher revenue in the prior year period was primarily due to revenues associated with the highly successful domestic home video release of Monsters, Inc. during the third quarter of fiscal 2002. Film revenue for the quarter ended September 27, 2003 consisted of $15.1 million from Finding Nemo, primarily from worldwide box office revenues, merchandise sales and ancillary royalties, offset by some home video release costs. Film revenue for the quarter ended September 27, 2003 also included $5.2 million from Monsters, Inc., which related primarily to revenues from merchandise sales and ancillary royalties and included a settlement on Monsters, Inc. merchandise revenue. This settlement resulted in an increase of $3.5 million to our revenue and $0.03 to our diluted net income per share. Also included in our film revenue for the third quarter ended September 27, 2003 was $7.1 million from our library titles for merchandise sales, as well as continuing worldwide home video sales, worldwide television licensing and ancillary royalties.

     Film revenue for the quarter ended September 28, 2002 consisted of $78.4 million from Monsters, Inc. and $21.7 million from our library titles. Revenues from Monsters, Inc. were primarily attributable to its highly successful September 2002 home video release, as well as some merchandise sales and other ancillary royalties. Revenues for our library titles were comprised of merchandise sales, continuing worldwide home video sales and other ancillary royalties. During the third quarter of 2002, we made certain favorable adjustments to previous home video reserve and home video and merchandising expense estimates which contributed to the home video revenues associated with Toy Story 2 and A Bug’s Life. These adjustments contributed approximately $0.14 to our diluted net income per share for the quarter ended September 28, 2002.

     Film revenue for the nine months ended September 27, 2003 was $89.0 million compared to $155.7 million in the corresponding prior year period. Film revenue for the first three quarters of fiscal 2003 included revenues which were primarily comprised of worldwide theatrical revenue, merchandise and ancillary royalties from Finding Nemo of $41.3 million. Monsters, Inc. contributed $17.4 million, consisting of merchandise sales, ancillary royalties, worldwide television and foreign home video revenues. Our library titles contributed $29.7 million, consisting of home video revenue, merchandise sales, and other ancillary royalties. In addition to the third quarter fiscal 2003 settlement referred to above, in the second quarter of fiscal 2003, we received updated information from Disney, which reflected higher home video returns for Monsters, Inc. than had been originally anticipated and resulted in a reduction to our revenues of $4.4 million and had a net impact of $0.04 to our diluted net income per share for that quarter.

     Film revenue for the nine months ended September 28, 2002 was comprised of worldwide theatrical revenue, home video sales, merchandise sales, and other ancillary royalties from Monsters, Inc. totaling $116.3 million. Revenues from our library titles of $37.4 million were comprised of merchandise sales, worldwide home video sales, and other ancillary royalties.

     On May 1, 2003, the home videos of two of our library titles, Toy Story and Toy Story 2, were placed on a sales moratorium. Although this strategy is designed to potentially increase sales over the lifetime of a title and to support a higher sales price upon re-release, it is difficult to predict the impact this strategy will actually have on our sales, particularly since these are our first feature films to be placed on a sales moratorium. See “Risk Factors — To meet

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our fiscal 2003 earnings projections, we are primarily dependent on our feature films and the accuracy of our forecasts.”

     Software revenue includes software license revenue from RenderMan®. Software revenue for the quarter and nine months ended September 27, 2003 was $2.7 million and $8.7 million, respectively, compared to $2.0 million and $6.6 million in the corresponding prior year periods. The increase in software revenues over the prior year periods resulted from increases in RenderMan® software licensing sales during such periods. We continue to expect ongoing variability in revenues derived from software licenses, and we expect future software revenues will be comparable with the average results from previous quarters.

     For both the quarter and nine months ended September 27, 2003, Disney accounted for 89% of our total revenue compared to 97% and 95%, respectively, for the corresponding prior year periods. The revenue from Disney consisted primarily of film related revenue. Because of our relationship with Disney under the Co-Production Agreement, Disney is expected to continue to represent significantly greater than 10% of our revenue in 2003 and for the near future.

Cost of Revenue

     Cost of film revenue for the quarter and nine months ended September 27, 2003 was $4.3 million and $15.0 million, respectively, compared to $21.3 million and $33.2 million in the corresponding prior year periods. Cost of film revenue represents amortization of capitalized film production costs. See “Capitalized Film Production Costs” below. For the quarter and nine months ended September 27, 2003, cost of film revenue represented amortization of capitalized film production costs associated with Finding Nemo, Monsters, Inc., Toy Story 2 and A Bug’s Life, and represented 15.6% and 16.9%, respectively, of total film revenue as compared to 21.2% and 21.3% in the corresponding prior year periods. Our cost of revenue as a percentage of film revenue may vary for any given period due to changes in the mix of film revenue as the gross profit varies by film, as well as for revisions to estimates on revenue to be received under the individual-film-forecast-computation method for an individual film. A change to an individual film’s estimate of revenue to be received may result in an increase or decrease to the amortization of the capitalized film costs relative to a previous period. For the quarter and nine months ended September 27, 2003, the decrease in our cost of revenue amortization percentage as compared to the prior periods was due in part to revisions to our estimates of ultimate revenue. The amortization of costs for our library titles and Monsters, Inc. have decreased relative to their respective amortization percentages in the prior year due to increases in their ultimate revenues. Additionally, for the quarter and nine months ended September 27, 2003, Finding Nemo has a lower cost amortization relative to Monsters, Inc. in the corresponding prior year periods due to the expectation that we will receive more revenues from Finding Nemo over its lifetime.

     Cost of software revenue consists of the direct costs and manufacturing overhead required to reproduce and package our software products, and for periods prior to fiscal 2003, amortization of purchased technology. Cost of software revenue as a percentage of the related revenue was less than 0.1% and 0.3%, respectively, for the quarter and nine months ended September 27, 2003 as compared to 7% and 6% for the corresponding prior year periods. Cost of software revenue for the quarter and nine months ended September 27, 2003 related primarily to direct costs and manufacturing overhead; however, for the quarter and nine months ended September 28, 2002 costs of software revenue related primarily to amortization of purchased technology of $120,000 and $360,000, respectively. We fully amortized this purchased technology against related license revenue by the end of fiscal 2002.

Operating Expenses

     Total operating expenses were $6.8 million and $23.7 million, respectively, for the quarter and nine months ended September 27, 2003 compared to $4.8 million and $13.8 million in the corresponding prior year periods. We continue to expect our operating expenses to increase as a result of the growth experienced by the studio as we ramp up to meet the demands of multiple films in production. Our operating expenses for the nine months ended September 27, 2003 include certain unanticipated expenses which occurred during the second quarter. For example, we expensed approximately $3.2 million of costs in that quarter related to a one-time incentive compensation to our employees in recognition of their contribution to the box office success of Finding Nemo, and we wrote off $1.9 million in costs previously capitalized for future film projects. In reviewing our projects in development, we determined it unlikely that these projects would be green-lighted for production within three years following their

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initial cost capitalization. Therefore, under SOP 00-2, these amounts were expensed in the second quarter of fiscal 2003 and are included in our operating expenses for the nine months ended September 27, 2003.

     Under the Co-Production Agreement, Disney reimburses us for half of certain general and administrative costs and certain research and development costs that benefit the productions. The funding received from Disney is treated as operating expense reimbursements. To the extent that personnel, facilities and other expenditures are not capitalized by us nor allocated to and paid for by Disney, and precede or are not subsequently followed by an increase in revenue, our business, operating results and financial condition will be materially adversely affected. For example, in February 2003, we approved our first feature film outside our existing Disney relationship (“Project 2006”) for production, and because it is our first feature film to be produced outside of the existing relationship with Disney, certain costs that have been reimbursed by Disney in our previous films will now be expensed as incurred.

     Research and Development. Research and development expenses consist primarily of salaries and support for personnel conducting research and development for our RenderMan® software and for our proprietary Marionette™ and Ringmaster™ animation and production management software and for creative development for future films. Research and development expenses increased to $3.1 million and $12.0 million, respectively, for the quarter and nine months ended September 27, 2003 from $2.0 million and $6.6 million for the corresponding prior year periods. The increased expenses in the third quarter of fiscal 2003 relative to the comparable prior year period were primarily due to an increase in employee and equipment costs, as well as an increase in expenses related to our short film projects. The increase for the nine months ended September 27, 2003 also included the higher employee related costs resulting from the one-time incentive compensation and the write-off of $1.9 million in previously capitalized development costs referred to above. Research and development expenses may continue to increase in future periods. To date, all research and development costs not reimbursed by Disney have been expensed as incurred.

     Sales and Marketing. Sales and marketing expenses consist primarily of salaries and related overhead, as well as public relations, advertising, technical support and trade show costs required to support our software sales. Sales and marketing expenses increased to $803,000 and $1.8 million, respectively, for the quarter and nine months ended September 27, 2003 from $404,000 and $858,000 in the corresponding prior year periods. The increase in costs for the third quarter of fiscal 2003 as compared to the comparable prior year period were due to increased public relations and compensation costs. The increase for the nine months ended September 27, 2003 also relates to higher employee related costs resulting from the one-time incentive compensation in the second quarter of 2003. We believe that sales and marketing expenses may continue to increase in future periods, particularly in the areas of public relations and corporate marketing related to our films.

     General and Administrative. General and administrative expenses consist primarily of salaries of management and administrative personnel, insurance costs, and legal and professional fees. General and administrative expenses increased to $2.9 million and $9.9 million, respectively, for the quarter and nine months ended September 27, 2003 from $2.3 million and $6.4 million in the corresponding prior year periods. The increase for the third quarter of fiscal 2003 as compared to the comparable prior year period was due primarily to increased legal and professional fees. The one-time incentive compensation recognized in the second quarter of fiscal 2003 also contributed to the increase for the nine months ended September 27, 2003. General and administrative expenses may continue to increase in future periods.

Other Income, Net

     Other income, net was $2.7 million and $8.6 million, respectively, for the quarter and nine months ended September 27, 2003, compared to $2.6 million and $7.7 million in the corresponding prior year periods. The increase in other income over the comparable prior year periods is primarily due to net gains on sales of investments.

Income Tax Expense

     Income tax expense for the quarter and nine months ended September 27, 2003 approximates the federal and state statutory income tax rate of 39.5% versus 40.4% in the same periods of the prior year.

Capitalized Film Production Costs

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     We had $117.3 million in capitalized film production costs as of September 27, 2003, consisting of costs relating to Toy Story 2, A Bug’s Life, Monsters, Inc., Finding Nemo, The Incredibles and Cars, all of which are being co-financed by Disney under the Co-Production Agreement. Capitalized film production costs also include costs related to Project 2006, our first Pixar-only financed film. In the second quarter of fiscal 2003, we wrote off $1.9 million in costs previously capitalized for future film projects. In reviewing our projects in development, we determined it unlikely that these projects would be green-lighted for production within three years following their initial cost capitalization. Therefore, under SOP 00-2, these amounts were expensed in the second quarter of fiscal 2003. All Toy Story capitalized film costs were fully amortized as of December 31, 1997.

Liquidity and Capital Resources

     Cash, cash equivalents and investments increased to $516.5 million by the end of the third quarter of fiscal 2003, an increase of $177.4 million since December 28, 2002. The increase was primarily due to cash received from Disney for our share of film revenue, particularly relating to Monsters, Inc. worldwide home video revenue, along with proceeds from stock option exercises, interest income and software revenue, offset by film production costs.

     Net cash provided by operating activities for the nine months ended September 27, 2003 of $125.0 million was primarily attributable to a decrease of $80.4 million in our receivable from Disney as a result of cash received and net income of $40.9 million, partially offset by capitalized film production costs of $39.8 million. Net cash used in investing activities of $151.0 million consisted primarily of investments in securities of $665.6 million, offset by proceeds from the sales of investment securities of $518.0 million. Net cash provided by financing activities consisted entirely of proceeds of $56.3 million from exercised stock options.

     As of September 27, 2003, our principal source of liquidity was approximately $516.5 million in cash, cash equivalents and investments. Our future capital commitments primarily consist of obligations to fund production costs of films and derivative products under the Co-Production Agreement and beyond. We are currently co-financing The Incredibles and Cars under the Co-Production Agreement. Under the Co-Production Agreement, we may co-finance other derivative works such as theatrical sequels, direct to home video sequels, interactive products and television productions. Additionally, we have already approved for production Project 2006, our first film beyond the Co-Production Agreement, and will finance production costs related to Project 2006 entirely. We also have obligations to pay portions of any revenue derived from each feature film produced under the Co-Production Agreement to our entertainment law firm in consideration for services rendered.

     Film Production Costs. For the remainder of fiscal 2003, we expect to spend approximately $17 million to $19 million, net of Disney’s film cost reimbursements, on direct film costs and other costs to fund our ongoing film projects under the Co-Production Agreement and beyond, which will directly impact working capital.

     Capital Expenditures. For the remainder of fiscal 2003, we expect to spend approximately $4 million to $6 million related to capital expenditures for our Emeryville headquarters and studio and other projects.

     We believe that our currently available funds and forecasted cash from operations for the remainder of fiscal 2003 will be sufficient to satisfy our currently anticipated cash needs for working capital and capital expenditures, including the production costs of The Incredibles and Cars, as well as the production and development costs associated with films not covered under the Co-Production Agreement. There can be no assurance that current and forecasted cash from operations will be sufficient to fund operations. To date, we have chosen to use our existing cash resources to fund both the construction on our Emeryville facility and film production costs. We may continue to use our cash resources for such expenditures, or may choose to finance such capital expenditures through issuance of additional equity or debt securities, by obtaining a credit facility or by some other financing mechanism.

Recent Accounting Pronouncements

     In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 143, “Accounting for Asset Retirement Obligations” (SFAS 143). SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS 143 applies to legal obligations associated with the retirement of long-lived

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assets that result from the acquisition, construction, development or normal use of the asset. As used in this Statement, a legal obligation results from existing law, statute, ordinance, written or oral contract, or by legal construction of a contract under the doctrine of promissory estoppel. SFAS 143 is effective for fiscal years beginning after June 15, 2002. The adoption of SFAS 143 has not had a material impact on our financial position or results of operations.

     In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146). SFAS 146 requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability has been incurred. We adopted SFAS 146 effective with the beginning of fiscal 2003. The adoption of SFAS 146 has not had an impact on our financial position or results of operations.

     In January 2003, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of FASB Statements No. 5, 57 and 107 and a Recission of FASB Interpretation No. 34” (FIN 45). FIN 45 clarifies the requirements for a guarantor’s accounting for and disclosure of certain guarantees issued and outstanding in interim and annual financial statements. FIN 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, the liability for the fair value of the obligation undertaken. The disclosure requirements are effective for financial statements of interim and annual periods after December 31, 2002. The initial recognition and initial measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002. We adopted the provisions of FIN 45 effective with the beginning of fiscal 2003. The adoption of FIN 45 has not had an impact on our financial statements or results of operations.

     In November 2002, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 00-21, “Accounting for Revenue Arrangement with Multiple Deliverables,” which addresses circumstances involving the delivery or performance of multiple products, services, and/or rights to use assets, and for which performance may occur at different points in time or over different periods of time. Issue No. 00-21 also addresses whether the different revenue-generating activities, or deliverables, are sufficiently separable, and there exists sufficient evidence of their fair values to separately account for some or all of the deliverables. The issue applies to all contractual arrangements under which a vendor will perform multiple revenue-generating activities. Issue No. 00-21 is effective for all revenue arrangements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. We adopted Issue No. 00-21 effective the beginning of fiscal 2003. The adoption of Issue No. 00-21 has not had a material impact on our financial statements or results of operations.

     In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” that amends SFAS No. 123, “Accounting for Stock-Based Compensation.” The standard provides for (1) alternative methods of transition for an entity that voluntarily changes to the fair-value method of accounting for stock-based employee compensation; (2) requires more prominent disclosure of the effects of an entity’s accounting policy decisions with respect to stock-based employee compensation on reported income; and (3) amends Accounting Principles Board (APB) Opinion No. 28, “Interim Financial Reporting,” to require disclosure of those effects in interim financial information. SFAS No. 148 is effective for fiscal years ending after December 15, 2002 and for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. We continue to account for employee stock options using the intrinsic value method in accordance with APB Opinion No. 25 and have adopted the additional disclosure requirements of SFAS No. 148.

Risk Factors

     The following is a discussion of certain factors that currently impact or may impact our business, operating results and/or financial condition. You should carefully consider these factors before making an investment decision with respect to our Common Stock.

To meet our fiscal 2003 earnings projections, we are primarily dependent on our feature films and the accuracy of our forecasts.

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     For the remainder of fiscal 2003, our revenue and operating results will be largely dependent upon (1) the timing and amount of worldwide revenues and distribution costs from Finding Nemo, Monsters, Inc. and other titles in our film library, (2) the timing, accuracy, and sufficiency of the information we receive from Disney to determine revenues and associated gross profits, (3) the timing and amount of non-film related revenues and expenses, (4) the accuracy of assumptions and judgments used to estimate certain revenues and associated gross profits, (5) the market price of our Common Stock and related volatility and (6) external socioeconomic and political events that are beyond our control.

Dependence on revenue from our feature films.

     Under the Co-Production Agreement, Pixar and Disney share equally in the profits of our animated feature films after Disney recovers its distribution fee and its marketing and distribution costs. Distribution costs include worldwide theatrical release costs, costs related to merchandise, Disney’s costs to market and distribute home videos in the United States and foreign markets, Disney’s distribution fee, and other costs including talent participation and residuals. We remain dependent on the timing, accuracy, and sufficiency of the information provided by Disney.

     For our business to be successful, our films must achieve box office success. While we have been successful in the release of our first five feature films, this level of success is unusual in the motion picture industry, and our future releases may not achieve similar results. For the remainder of 2003, we will be dependent on the continuing success of Finding Nemo. Although Finding Nemo has had tremendous success in the domestic theatrical market and in most foreign markets where it has been released, as well as a successful initial domestic home video release, unless Finding Nemo achieves continued box office success in the remaining territories and is successful in home video, television licensing, and merchandise sales, it may not generate sufficient revenue for us to meet our projections in 2003 and beyond.

     A significant portion of our anticipated revenues for the remainder of fiscal 2003 is based on the assumption that Finding Nemo will be a success in the domestic home video, worldwide theatrical and worldwide merchandising markets. Our projections assume approximately 22 to 24 million units of the Finding Nemo home video will be sold in the U.S. during the fourth quarter of fiscal 2003. In addition, our projections are based on the assumption that Finding Nemo will achieve $400 million in international box office receipts, of which $300 million we estimate will be recognized in fiscal 2003. These projections for home video sales and international box office receipts are significantly higher than our previous titles, and there is no assurance that these projections can be achieved. Therefore, if Finding Nemo does not generate sufficient worldwide box office receipts, domestic home video sales, or worldwide merchandise sales, it would adversely impact our 2003 operating results and our ability to meet our targeted results. In addition, for the remainder of 2003, we expect continued contributions from Monsters, Inc. and our library titles. If Monsters, Inc. or our library titles do not generate sufficient revenues, our 2003 results could be adversely affected. To date, we have recognized most of the revenues we expect to recognize over the lifetime of the Toy Story franchise and A Bug’s Life. For Monsters, Inc., we have recognized essentially all of the theatrical revenues and a substantial portion of the home video and merchandise revenues. Although our forecast assumes some continued revenues from these titles, there can be no assurance that they will be sufficient to achieve our 2003 earnings projection.

Forecasting film revenue and associated gross profits from our feature films is extremely difficult.

     Although we have experienced a successful track record with the releases of our feature films, it is difficult to predict the ultimate box office success of Finding Nemo. Even with Finding Nemo experiencing a very successful theatrical run in the U.S. and other foreign territories where it has been released, it is difficult to predict the ultimate worldwide theatrical revenues as well as related home video, television licensing, merchandising and ancillary revenue streams. While customer acceptance is initially measured by box office success, customer acceptance within each follow-on product category, such as home video, merchandise or television, depends on factors unique to each type of product, such as pricing, competitive products, and the time of year or state of the economy into which a product is released, among many other factors. In addition, we have found that the degree of customer acceptance varies widely among foreign countries. While box office success is often a good indicator of general customer acceptance, the relative success of follow-on products is not always directly correlated, and the degree of correlation is difficult to predict.

     It is also difficult to forecast the amount of revenues from Monsters, Inc. and the titles in our film library. The revenues generated from continued home video and merchandise sales can fluctuate due to various market factors. Because the revenues from films nearing the end of life cycle tend to be relatively small, minor fluctuations can

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result in notable variances from forecast. Both Toy Story and Toy Story 2 home videos are currently subject to a sales moratorium, which began on May 1, 2003. Although this strategy is designed to increase potential sales over the lifetime of a title and to support a higher sales price upon re-release, it is difficult to predict the actual impact of this strategy, particularly since these are our first titles to be placed on a sales moratorium, and it may not generate the results we expect in future years.

     With respect to the difficulty of forecasting the timing of revenues, Disney distributes our films and film-related products and therefore determines the timing of product releases. While the timing of domestic release is typically known well in advance of release, the timing of international releases is less predictable. A foreign product release is often marked by a rollout across many countries over the course of many months. Therefore, the timing of international revenues is inherently more difficult to predict than the timing of domestic revenues.

     In addition, the amount of revenue recognized in any given quarter or quarters from all of our films depends on the timing, accuracy, and sufficiency of the information we receive from Disney to determine revenues and associated gross profits. Although we obtain from Disney the most current information available to recognize our share of revenue and to determine our film gross profit, Disney may make subsequent adjustments to the information that it has provided, which could have a material impact on us in later periods. For instance, towards the end of the life cycle for a revenue stream, Disney may inform us, and has in the past informed us, of additional distribution costs to those previously forecasted. Such adjustments have and may continue to impact our revenue share and our film gross profit. In addition, through information we obtain from other sources, we may make certain judgments and/or assumptions and adjust the information we receive from Disney. For example, in the past, we have made adjustments to our home video revenues for estimates on return reserves that may differ from those reported by Disney. The estimates on reserves may be adjusted periodically based on actual rates of returns, estimated sell-throughs and the related inventory levels in the distribution channel, as well as other business and industry information. For example, during the third quarter of fiscal 2003, we received a settlement on Monsters, Inc. merchandise revenue, which resulted in an increase of $3.5 million to our revenues and $0.03 to our diluted net income per share, and during the second quarter of fiscal 2003, we recognized an adjustment, which reduced our revenues for Monsters, Inc. domestic home video after we received updated information from Disney which reflected higher returns of domestic home video than had been originally anticipated. The adjustment in the second quarter of fiscal 2003 reduced our home video revenues by $4.4 million and had a net impact of $0.04 to our diluted net income per share. Furthermore, we may utilize margin normalization in estimating associated costs, such as with merchandising or home video, in accordance with the provisions of Statement of Position 00-2 — “Accounting by Producers or Distributors of Films” (SOP 00-2). Due to these factors, the amount and timing of our future revenues and associated expenses from our films are difficult to forecast, and it is possible, in any given quarter, that we will not recognize sufficient film revenue to generate significant earnings. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

     With respect to capitalized film production costs, our policy is to amortize these costs over the expected revenue streams as we recognize revenues from the associated films. The amount of film costs that will be amortized each quarter will depend on how much future revenue we expect to receive from each film. Unamortized film production costs are compared with net realizable value each reporting period on a film-by-film basis. If estimated remaining gross revenues are not sufficient to recover the unamortized film production costs, the unamortized film production costs will be written down to net realizable value. In any given quarter, if we lower our previous forecast with respect to total anticipated revenue from any individual feature film, we would be required to accelerate amortization of related film costs, resulting in lower gross margins. Such lower gross margins would adversely impact our business, operating results, and financial condition.

Forecasting our operating expenses is extremely difficult.

     Our operating expenses will continue to be extremely difficult to forecast. We budget the direct costs of the Pictures with Disney, and we share such costs equally. We capitalize our share of these direct costs of film production in accordance with SOP 00-2. A substantial portion of all of our other costs is incurred for the benefit of feature films (“Overhead”), including research and development expenses and general and administrative expenses. Portions of our Overhead are included in the budgets for the Pictures under the Co-Production Agreement, and we will share such costs equally with Disney under the Co-Production Agreement. With respect to the portion of our Overhead that is not reimbursed by Disney, we either (1) capitalize such portion as film production costs, if required

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under SOP 00-2, or (2) charge it to operating expense in the period incurred. Since a substantial portion of our Overhead is related to the Pictures, and is therefore reimbursed by Disney, and since we capitalize other amounts in accordance with SOP 00-2, our reported operating expenses for the first nine months of fiscal 2003 have not reflected, and future reported operating expenses will not reflect, our true level of spending on the production of animated feature films, related products and Overhead. Further, as we begin production of our films beyond the Co-Production Agreement, we expect our operating expenses to continue to increase to the extent that they are not capitalized or not shared with Disney.

Film production budgets may increase, and film production spending may exceed such budgets.

     Our future film budgets may continue to increase due to factors including, but not limited to, (1) escalation in compensation rates of people required to work on our current projects, (2) number of personnel required to work on our current projects, (3) equipment needs, (4) the enhancement of existing or the development of new proprietary technology and (5) the expansion of our facilities to accommodate the growth of the studio. The budget for The Incredibles and Cars and subsequent films and related products are expected to be greater than the budgets for our previous films. Under the Co-Production Agreement, we will continue to finance the budgets of The Incredibles and Cars equally with Disney. In addition, we have approved for production our first Pixar-only financed film, “Project 2006.” Due to production exigencies, which are often difficult to predict, it is not uncommon for film production spending to exceed film production budgets, and our current projects may not be completed within the budgeted amounts. In addition, when production of each film is completed, we may incur significant carrying costs associated with transitioning personnel on creative and development teams from one project to another. These carrying costs, which are currently shared with Disney and treated as film costs, increase overall production budgets and could have a material adverse effect on our results of operations and financial condition.

Software revenue.

     We continue to maintain minimal emphasis on and devote limited resources to the commercialization of software products relative to our core business of producing films. Our fiscal 2003 earnings projections include revenues attributable to non-film related sources including software revenue; however, there can be no assurance that the timing and amount of such revenues will be sufficient to meet our 2003 earnings projection.

Other non-film revenue and expenses.

     Our fiscal 2003 earnings are expected to include our forecast of other non-film related sources such as interest income and our effective tax rate. Interest income is difficult to predict and can fluctuate depending on our cash balance as well as external factors beyond our control, such as economic conditions and interest rates available to us during the year. For example, although our average cash, cash equivalents and investment balances increased during fiscal 2002, interest income decreased when compared to fiscal 2001 due to declining interest rates during fiscal 2002. Income tax expense may also fluctuate. Our income tax rate for fiscal 2002 approximated statutory rates, and we expect that our income tax rate for fiscal 2003 will also approximate statutory rates; however, our effective tax rate may fluctuate in future periods. There can be no assurance that the amount of other non-film revenues and expenses forecasted such as those noted above will be achieved to meet our fiscal 2003 earnings projection.

Our operating results have fluctuated in the past, and we expect such fluctuations to continue.

     Our revenues fluctuate significantly.

     We continue to expect significant fluctuations in our future quarterly and annual revenues because of a variety of factors, including the following:

	•		the timing of the domestic and international theatrical releases of our animated feature films,
	•		the success of our animated feature films,
	•		the timing of the release of related products into their respective markets, such as home videos, television, and merchandising,

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	•		the demand for such related products, which is often a function of the success of the related animated feature film,
	•		Disney’s costs to distribute and promote our feature films and related products under the Co-Production Agreement,
	•		Disney’s success at marketing our feature films and related products under the Co-Production Agreement,
	•		the timing and accuracy of information received from Disney and other sources on which we base estimates of revenue to be recognized from our animated feature films and related products,
	•		the timing and amount of non-film related revenues, such as the licensing of our software,
	•		the introduction of new feature films or products by our competitors, and
	•		external socioeconomic and political events that are beyond our control.

     In particular, since our revenue under the Co-Production Agreement is directly related to the success of our animated feature films, our operating results are likely to fluctuate depending on the level of success of our animated feature films and related products. The revenues derived from the production and distribution of an animated feature film depend primarily on the film’s acceptance by the public, which cannot be predicted and does not necessarily bear a direct correlation to the production or distribution costs incurred. The commercial success of a motion picture also depends upon promotion and marketing, production costs and other factors. Further, the theatrical success of a feature film can be a significant factor in determining the amount of revenues generated from the sale of the related products.

     Our operating expenses fluctuate.

     Operating expenses for the first nine months of fiscal 2003 increased in comparison to the same period in fiscal 2002, and we expect to continue to increase our operating expenses to fund greater levels of research and development, to ramp up to meet the demands of multiple films in production and to expand operations. In addition, we expect our spending levels may increase due to the following:

	•		continued investment in proprietary software systems,
	•		continued and potentially increasing competition costs for creative, technical and administrative talent,
	•		increased costs associated with the expansion of our facilities,
	•		increased number of personnel required to support studio growth as we have multiple films in parallel production,
	•		increased investment in creative development and our Pixar-only financed films, and
	•		increased investment in administrative functions to support our expanding operations.

     A portion of our operating expenses that are allocable to film productions is either capitalized by us or reimbursed by Disney under the Co-Production Agreement. To the extent that we do not capitalize (or Disney does not reimburse) the increases in expenses, our operating expenses will significantly increase in 2003. In addition, as we increase the resources allocated to our productions beyond our feature film Cars, which is the last film to be co-financed with Disney under the current Co-Production Agreement, we expect our operating expenses to increase significantly.

Our scheduled successive releases of feature films will continue to place a significant strain on our resources.

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     In order to meet our obligations pursuant to the Co-Production Agreement, we have established parallel creative teams so that we can develop more than one film at a time. These teams are currently working primarily on The Incredibles and Cars, as well as future projects, including Project 2006, our first Pixar-only financed film, as we move towards producing one feature film per year. We have only produced and released five feature films to date and have limited experience with respect to producing animated feature films in parallel. Due to the strain on our personnel from the effort required for the release of an upcoming film and the time required for creative development of future films, it is possible that we would be unable to release a new film in successive years. In the past, we have been required, and may continue to be required, to expand our employee base, increase capital expenditures and procure additional resources and facilities in order to accomplish the scheduled releases of our animated feature films. This growth and expansion has placed, and continues to place, a significant strain on our resources. We cannot provide any assurances that The Incredibles, Cars, Project 2006 or any future animated film will be released as targeted or that this strain on resources will not have a material adverse effect on our business, financial condition or results of operations. In addition, John Lasseter’s availability has been a key ingredient in the successful completion of our prior films. As we move towards achieving one film a year, there has been and will continue to be additional demands placed on his availability. In addition to Mr. Lasseter’s role as our Creative Executive, he is also directing his next feature film, Cars. A lack of his availability may adversely impact the success and timing of our future films.

     We continuously implement a variety of new and upgraded operational and financial systems, procedures and controls, including improvement and maintenance of our accounting system, other internal management systems and backup systems. Our growth and these diversification activities, along with the corresponding increase in the number of our employees and our rapidly increasing costs, have resulted in increased responsibility for our management team. We will need to continue to improve our operational, financial and management information systems, to hire, train, motivate and manage our employees, to integrate them into Pixar and to provide adequate facilities and other resources for them. We cannot provide any assurance we will be successful in accomplishing all of these activities on a timely and cost-effective basis. Any failure to accomplish one or more of these activities on a timely and cost-effective basis would have a material adverse effect on our business, financial condition and results of operations.

The Co-Production Agreement imposes several risks and restrictions on us.

We are dependent on Disney for the distribution and promotion of our feature films and related products.

     The decisions regarding the timing of the theatrical release and related products and which of Disney’s motion pictures and related products will receive extensive promotional support from Disney are important factors in determining the success of our motion pictures and related products. Under the terms of the Co-Production Agreement, we have some general protections with respect to the marketing and distribution of our feature films in the form of commitments by Disney as to release windows, the timing of release of other Disney family films and marketing obligations. We ultimately do not control (1) the manner in which Disney distributes our animated feature films and related products, (2) the number of theaters to which Disney distributes our feature films, (3) the specific timing of release of our feature films and related products or (4) the specific amount or quality of marketing and promotional support of the feature films and related products as well as the associated promotional and marketing budgets. Because Disney co-finances the films developed and produced under the Co-Production Agreement, distributes the films under the “Walt Disney Pictures” label and enjoys substantial financial benefits in the event that such films achieve significant box office revenues, we believe that Disney desires such films to be successful. Nonetheless, Disney could make certain decisions as to marketing, distribution or promotion of the animated feature films or related products or the marketing and promotion of its own animated or other family films that could have a material adverse effect on our business, operating results or financial condition. In addition, the costs for marketing, distribution and promotion of the films and related products are incurred well in advance of the release of such films and products, and we experience a delay in the receipt of proceeds from such films and products until after Disney recovers such costs. We are also dependent on Disney for receiving accurate information on a timely basis on which we base estimates to recognize revenue and associated gross profit from the animated feature films and related products. If we fail to receive accurate information from Disney, or fail to receive it on a timely basis, it could have a material adverse effect on our business, operating results or financial condition.

Disney has an exclusive arrangement with us.

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     We have agreed not to release or authorize the release of any of our feature length animated theatrical motion pictures, other than our feature films that we produce under the Co-Production Agreement, until twelve months from our delivery of the fifth original feature film under the Co-Production Agreement. We currently anticipate that we will not deliver the fifth Picture, Cars, until 2005 at the earliest. However, now that we have delivered Finding Nemo, the third original feature film under the Co-Production Agreement, to Disney, we are free to enter into any agreement with any third party for the development, production or distribution of any feature length animated theatrical motion picture (other than the Pictures). We have also agreed that we will not develop or produce any rides or attractions for major theme parks not owned or operated by Disney, and to give Disney a right to negotiate with respect to animated television productions or animated made-for-home video productions that we propose to produce during the term of the Co-Production Agreement. Disney, however, is not similarly restricted by the exclusivity provisions that bind us under the Co-Production Agreement and, therefore, may develop, produce, or distribute other feature length animated and computer animated theatrical motion pictures itself or enter into similar agreements with third parties. See “Risk Factors — We experience intense competition with respect to our animated feature films, animation products, and software” below.

We have an obligation to co-finance production costs.

     Under the Co-Production Agreement, we will continue to co-finance each of the two remaining unreleased original animated feature films and may co-finance other related products to be developed and produced pursuant to the Co-Production Agreement. We co-financed A Bug’s Life, Toy Story 2, Monsters, Inc. and Finding Nemo. We are currently co-financing The Incredibles and Cars under the Co-Production Agreement. However, we also have approved for production and have begun financing Project 2006, our first Pixar-only financed film. If our feature films and related products do not generate proceeds sufficient to more than offset our share of their production costs, our business, operating results and financial condition will be materially adversely affected.

Disney retains the exclusive distribution and exploitation rights.

     We share equally with Disney in the profits of each Picture and any related merchandise after Disney recovers certain costs; however, Disney retains the exclusive distribution and exploitation rights to all of our feature films, all characters and story elements of our feature films and all related products we develop under the Co-Production Agreement. Accordingly, except in certain specified circumstances, we are not able to exploit or distribute any of our feature films or characters or elements of any of our feature films or related products developed under the Co-Production Agreement without a license from Disney. We cannot provide any assurances that such a license would be available to us on commercially reasonable terms or at all.

Disney can terminate the agreement under various circumstances.

     Under the terms of the Co-Production Agreement, Disney may terminate the agreement under certain circumstances. For example, Disney is entitled to terminate the Co-Production Agreement in the event that certain types of competitors directly or indirectly acquire or control a 50% or greater ownership interest in Pixar or Pixar merges or consolidates into such a competitor. Disney would not lose any of its rights to distribute and exploit all feature films and all characters and elements of our feature films and other products we develop under the Co-Production Agreement, except for feature films or related products then in development or production as to which Disney does not elect to proceed, as to which we would regain the rights subject to a lien in favor of Disney for the costs advanced to date. Further, in the event that Disney terminated the Co-Production Agreement, we would be required to seek alternative channels for distribution of our animated feature films and related products.

There are significant risks associated with the motion picture industry.

     The completion and commercial success of a motion picture is extremely unpredictable, and the motion picture industry involves a substantial degree of risk. Each motion picture is an individual artistic work, and its commercial success is primarily determined by audience reaction, which is unpredictable. The completion and commercial success of a motion picture also depends upon other factors, such as:

•

talent and crew availability,

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	•		financing requirements,
	•		distribution strategy, including the time of the year and the number of screens on which it is shown,
	•		the number, quality and acceptance of other competing films released into the marketplace at or near the same time,
	•		critical reviews,
	•		the availability of alternative forms of entertainment and leisure time activities,
	•		general socioeconomic conditions and political events,
	•		weather conditions, and
	•		other tangible and intangible factors.