ATARI INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934


For the quarterly period ended December 31, 2003		Commission File No. 0-27338

ATARI, INC.

(Exact name of registrant as specified in its charter)


DELAWARE		13-3689915
(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification No.)

417 FIFTH AVENUE, NEW YORK, NY 10016
(Address of principal executive offices)

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (212) 726-6500

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 Exchange Act Rule 12b-2).

Yes x No o

As of February 12, 2004, there were 121,215,388 of the registrant’s Common Stock outstanding.

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		CONSOLIDATED BALANCE SHEETS
		CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
		CONSOLIDATED STATEMENTS OF CASH FLOWS
		CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIENCY)
		NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures about Market Risk
	Item 4. Controls and Procedures
PART II. OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURE
AMENDED AND RESTATED BY-LAWS
AMENDMENT NO. 1 TO AMENDED AND RESTATED BY-LAWS
SIXTH AMENDMENT TO CREDIT AGREEMENT
1ST AMENDMENT TO INTERCREDITOR/SUBORDINATION AGMT
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
CERTIFICATION OF CHIEF FINANCIAL OFFICER
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
CERTIFICATION OF CHIEF FINANCIAL OFFICER

ATARI, INC. AND SUBSIDIARIES
DECEMBER 31, 2003 QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS


		Page

PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Balance Sheets as of March 31, 2003 and December 31, 2003 (unaudited)		3
	Consolidated Statements of Operations and Comprehensive Income for the Three Months and Nine Months Ended December 31, 2002 (unaudited), and for the Three Months and Nine Months Ended December 31, 2003 (unaudited)		4
	Consolidated Statements of Cash Flows for the Nine Months Ended December 31, 2002 and 2003 (unaudited)		5
	Consolidated Statements of Stockholders’ Equity (Deficiency) for the Nine Months Ended March 31, 2003 and for the Nine Months Ended December 31, 2003 (unaudited)		7
	Notes to the Consolidated Financial Statements (unaudited)		8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
Item 3.	Quantitative and Qualitative Disclosures about Market Risk		35
Item 4.	Controls and Procedures		35
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings		36
Item 6.	Exhibits and Reports on Form 8-K		37
Signature			38

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

ATARI, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)


				March 31,			December 31,
				2003			2003

							(unaudited)
ASSETS
Current assets:
		Cash		$	815		$	9,040
		Receivables, net			47,053			100,377
		Inventories, net			37,827			42,875
		Income taxes receivable			395			424
		Due from related parties			2,656			10,999
		Prepaid expenses and other current assets			16,958			13,107

			Total current assets		105,704			176,822
Advances to related parties					32,184			—
Property and equipment, net					14,727			13,507
Goodwill, net of accumulated amortization of $26,116 in both periods					70,224			70,224
Other intangible assets, net of accumulated amortization of $619 and $1,125, at March 31, 2003 and December 31, 2003, respectively					2,081			1,575
Other assets					7,162			8,125

			Total assets	$	232,082		$	270,253

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIENCY)
Current liabilities:
		Accounts payable		$	39,587		$	62,604
		Accrued liabilities			31,872			35,058
		Revolving credit facility			10,651			6,880
		Current portion of related party medium-term loan			40,000			—
		Related party credit facility			44,800			—
		Royalties payable			13,653			19,568
		Income taxes payable			1,965			1,309
		Short-term deferred income			2,077			2,077
		Due to related parties			12,747			9,072

			Total current liabilities		197,352			136,568
Related party debt					124,610			—
Deferred income					4,131			574
Other long-term liabilities					2,907			936

			Total liabilities		329,000			138,078

Commitments and contingencies

Stockholders’ equity (deficiency):
	Preferred stock, $0.01 par value, 5,000 shares authorized, none issued or outstanding				—			—
	Common stock, $0.01 par value, 300,000 shares authorized, 69,920 and 121,215 shares issued and outstanding at March 31, 2003 and December 31, 2003, respectively				699			1,212
	Additional paid-in capital				486,053			735,912
	Accumulated deficit				(586,851	)		(608,123	)
	Accumulated other comprehensive income				3,181			3,174

			Total stockholders’ (deficiency) equity		(96,918	)		132,175

			Total liabilities and stockholders’ (deficiency) equity	$	232,082		$	270,253

The accompanying notes are an integral part of these consolidated financial statements.

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ATARI, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(in thousands, except per share data)
(unaudited)


				Three Months						Nine Months
				Ended						Ended
				December 31,						December 31,

				2002			2003			2002			2003

Net revenues				$	210,594		$	190,607		$	449,564		$	402,540
Cost of goods sold					104,142			93,916			218,062			202,712

		Gross profit			106,452			96,691			231,502			199,828
Selling and distribution expenses					39,758			37,339			81,122			71,270
General and administrative expenses					14,190			7,924			30,904			25,157
In-process research and development					—			—			7,400			—
Research and development					16,976			26,928			60,461			72,734
Gain on sale of development project to a related party					—			(3,744	)		—			(3,744	)
Depreciation and amortization					1,856			2,811			5,850			6,757

		Operating income			33,672			25,433			45,765			27,654
Interest expense, net					3,356			453			10,678			7,215
Other income (expense)					220			(1,880	)		(2,844	)		(2,297	)

		Income before provision for income taxes			30,536			23,100			32,243			18,142
Provision for income taxes					482			81			2,167			63

		Net income		$	30,054		$	23,019		$	30,076		$	18,079
Dividend to parent					—			—			—			(39,351	)

		Net income (loss) attributable to common stockholders		$	30,054		$	23,019		$	30,076		$	(21,272	)

Basic net income (loss) per share attributable to common stockholders				$	0.43		$	0.19		$	0.43		$	(0.24	)

Diluted net income (loss) per share attributable to common stockholders				$	0.39		$	0.19		$	0.43		$	(0.24	)

Basic weighted average shares outstanding					69,891			121,170			69,847			88,981

Diluted weighted average shares outstanding					80,103			121,325			80,078			88,981

Net income				$	30,054		$	23,019		$	30,076		$	18,079
Other comprehensive income:
	Foreign currency translation adjustments				(22	)		(99	)		266			(7	)

			Comprehensive income	$	30,032		$	22,920		$	30,342		$	18,072

The accompanying notes are an integral part of these consolidated financial statements.

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ATARI, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)


				Nine Months			Nine Months
				Ended			Ended
				December 31,			December 31,
				2002			2003

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income				$	30,076		$	18,079
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
	Depreciation and amortization				5,850			6,757
	Loss on transfer of investment held at cost				—			1,750
	Write-down of investment held at cost				3,622			—
	Amortization of discount on related party debt				2,152			1,339
	Accrued interest				6,287			1,860
	Accretion of interest on short-term promissory notes				66			—
	Amortization of deferred financing fees				806			2,149
	Deferred income				457			(3,557	)
	Write-off of property and equipment				858			37
	In-process research and development related to acquisition of Shiny Entertainment, Inc.				7,400			—
Changes in operating assets and liabilities:
		Receivables, net			(61,359	)		(53,325	)
		Inventories, net			(7,382	)		(5,048	)
		Due from related parties			(1,566	)		(7,783	)
		Due to related parties			6,069			(5,325	)
		Prepaid expenses and other current assets			(5,079	)		5,596
		Accounts payable			13,534			23,979
		Accrued liabilities			19,690			2,813
		Royalties payable			18,465			7,114
		Income taxes payable			1,362			(711	)
		Income taxes receivable			5,364			2
		Other long-term liabilities			2,007			(231	)
		Other assets			2,099			(637	)

			Net cash provided by (used in) operating activities		50,778			(5,142	)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment					(4,867	)		(4,040	)
Advances to related parties					(10,296	)		(14,368	)
Acquisition of Shiny Entertainment, Inc., net of nominal cash acquired					(34,010	)		—

			Net cash used in investing activities		(49,173	)		(18,408	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Payment of related party credit facility, net					(18,260	)		—
Borrowings from related party medium-term loan					48,278			—
Payments under short-term promissory notes					(16,157	)		—
Payments of BNP Paribus revolving credit facility					(24,888	)		—
Borrowings (payments) of General Electric Capital Corporation Senior Credit Facility, net					9,157			(3,771	)
Proceeds from exercise of stock options					103			448
Proceeds from employee stock purchase plan					200			103
Net proceeds from public stock offering					—			34,894

			Net cash (used in) provided by financing activities		(1,567	)		31,674
Effect of exchange rates on cash					94			101

Net increase in cash					132			8,225
Cash – beginning of fiscal period					4,685			815

Cash – end of fiscal period				$	4,817		$	9,040

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		Nine Months		Nine Months
		Ended		Ended
		December 31,		December 31,
		2002		2003

SUPPLEMENTAL CASH FLOW INFORMATION

SUPPLEMENTAL DISCLOSURE OF OPERATING ACTIVITIES:
Cash paid for interest			3,713		5,738

Cash paid for taxes			—		730


SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING ACTIVITIES:
Acquisition of Shiny Entertainment, Inc.:
Fair value of assets acquired		$	50,776	$	—
Less: Short-term promissory notes issued to seller and others			16,059		—
	Assumption of stock options		672		—
	Other payments due seller		31		—
	Cash acquired		4		—

Acquisition, net of cash acquired		$	34,010	$	—


Acquisition of Atari license for 2,000 shares of common stock			—		8,500


SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES:
Net debt exchanged for 39,030 shares of common stock:
Related party debt, revolving credit facility and related party medium-term loan prior to recapitalization of debt		$	—	$	212,429
Less: Offset of advances to related parties against related party debt			—		46,552

Net debt exchanged for common stock		$	—	$	165,877

Issuance of shares in lieu of partial royalty payment			—		1,199
Assumption of Shiny Entertainment, Inc. employee stock purchase plan			672		—

The accompanying notes are an integral part of these consolidated financial statements.

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ATARI, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIENCY)
(in thousands)


										Accumulated
	Common				Additional					Other
	Stock		Common		Paid-In		Accumulated			Comprehensive
	Shares		Stock		Capital		(Deficit)			Income			Total

Balance, July 1, 2002		69,826	$	698	$	485,759	$	(604,921	)	$	3,135		$	(115,329	)
Issuance of common stock pursuant to employee stock purchase plan		46		—		125		—			—			125
Exercise of stock options		48		1		115		—			—			116
Issuance of warrants to external developer		—		—		54		—			—			54
Net income		—		—		—		18,070			—			18,070
Foreign currency translation adjustment		—		—		—		—			46			46

Balance, March 31, 2003		69,920		699		486,053		(586,851	)		3,181			(96,918	)
Issuance of common stock pursuant to employee stock purchase plan		54		1		102		—			—			103
Exercise of stock options		97		1		447		—			—			448
Net income		—		—		—		18,079			—			18,079
Foreign currency translation adjustment		—		—		—		—			(7	)		(7	)
Cashless exercise of warrants		13		—		—		—			—			—
Issuance of common stock in lieu of partial royalty payment		280		3		1,196		—			—			1,199
Issuance of 39,030 common shares as part of the Company’s recapitalization in exchange for cancellation of related party debt, related party credit facility and related party medium-term loan		39,030		390		165,487		—			—			165,877
Dividend to parent as part of the recapitalization of related party debt to common shares		—		—		39,351		(39,351	)		—			—
Issuance of 2,000 common shares for license of the Atari name		2,000		20		8,480		—			—			8,500
Issuance of 9,821 common shares in secondary offering, net of expenses		9,821		98		34,796		—			—			34,894

Balance, December 31, 2003 (unaudited)		121,215	$	1,212	$	735,912	$	(608,123	)	$	3,174		$	132,175

The accompanying notes are an integral part of these consolidated financial statements.

Page 7

ATARI, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER MATTERS

Nature of Business and Other Matters

Atari, Inc., a Delaware corporation (the “Company”), is a leading worldwide developer, publisher and distributor of interactive entertainment software for use on various platforms, including personal computers (“PCs”), Sony’s PlayStation and PlayStation2, Microsoft’s Xbox and Nintendo’s GameCube, Gameboy and Gameboy Advance. The Company derives its revenues primarily from the sale of its created, published, licensed and purchased products to mass merchants, specialty software stores, computer superstores and distributors located throughout North America and also in various international locations.

In May 2003, the Company changed its name to Atari, Inc. and changed its trading symbol on the NASDAQ National Market to “ATAR”. The Company obtained rights to use the Atari name through a license from Infogrames Entertainment SA, a French corporation (“Infogrames SA”) which Infogrames SA acquired as part of the acquisition of Hasbro Interactive. The Company believes that the Atari brand, which is largely credited with launching the video game industry, continues to carry a level of respect, recognition and legacy for innovation that will enhance the Company’s reputation and improve consumer recognition of its products. As of May 2003, all of the Company’s products are published, distributed and marketed under the Atari brand.

On November 12, 2002 (last amended December 23, 2003), the Company obtained a 30-month $50.0 million secured revolving credit facility (“Senior Credit Facility”) with General Electric Capital Corporation (“GECC”) (Note 8) which was used to fund the Company’s working capital and general corporate needs and to provide funding to related parties which are wholly-owned by Infogrames SA. Infogrames SA owns approximately 67% of the Company, after the exercise of an underwriter’s over-allotment option on October 21, 2003, directly and through its wholly-owned subsidiaries California U.S. Holdings, Inc. (“CUSH”) and Atari Interactive, Inc. (“Atari Interactive”). (See Offering below.) As part of the most recent amendment under the GECC Senior Credit Facility, the Company will no longer provide funding to related parties.

During September 2003, the Company entered into a series of transactions to restructure the Company’s debt and equity through a recapitalization of debt and an underwritten secondary public offering of common stock (“Offering”). In conjunction with the recapitalization of debt, the Company secured long-term rights to the Atari name (“Atari License”).

Recapitalization

In September 2003, the Company, Infogrames SA, and CUSH entered into an agreement (“Recapitalization Agreement”) resulting in the exchange of all of the Company’s net related party debt with Infogrames SA and certain of its wholly-owned subsidiaries totaling $165.9 million, into 39,029,877 shares of the Company’s common stock immediately prior to the Offering. The conversion price was consistent with the Offering price of $4.25 per share. The converted debt consisted of the following outstanding amounts at September 18, 2003: $48.3 million of a medium-term loan, $44.8 million of a revolving credit agreement with Infogrames SA, $46.3 million of non-interest bearing subordinated convertible notes and $73.1 million of 5% subordinated convertible notes. The Recapitalization Agreement provided for an offset of previously provided advances to Atari Interactive and Atari Australia Pty. Ltd. (“Atari Australia”) of $44.7 million and $1.9 million, respectively. Accordingly, at December 31, 2003, no amounts remain outstanding in Advances to Related Parties, Current Portion of Related Party Medium-Term Loan, Related Party Credit Facility and Related Party Debt.

In connection with the Recapitalization Agreement, the Company issued stock at a more favorable rate than was available, at the holder’s option, under the original terms of the 5% subordinated convertible notes. The incremental value of

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the additional stock issued was reported as a dividend to Infogrames SA for $39.4 million, which had no impact on total stockholders’ equity and has been reported as a charge in computing net income (loss) attributable to common stockholders.

Atari License

In connection with the Recapitalization Agreement, Infogrames SA caused Atari Interactive to extend the term of the license under which the Company uses the Atari name to ten years expiring on December 31, 2013. The Company issued 2,000,000 shares of its common stock to Atari Interactive for the extended license and will pay a royalty equal to 1% of the Company’s net revenues during years six through ten of the extended license. The Company recorded a deferred charge of $8.5 million, which is being amortized at the rate of approximately $0.3 million per month. The monthly amortization is based on the total estimated cost to be incurred by the Company over the ten-year license period. At December 31, 2003, $3.4 million of this charge is included in Prepaid Expenses and Other Current Assets with the remaining $4.2 million, net of $0.9 million of amortization, included in Other Assets.

Offering

On September 24, 2003, the Company offered to the public 9,820,588 new shares of the Company’s common stock at an offering price of $4.25 per share. The net proceeds to the Company after all costs were $34.9 million. The Company used $3.9 million of the net proceeds to repay indebtedness outstanding under its credit facility with GECC. The remaining proceeds are being used to pay costs of developing video game software and to meet general working capital needs.

Additionally, on September 24, 2003, Infogrames SA sold 17,179,412 shares of the Company’s common stock as part of the Offering. The Company did not receive any proceeds from the sale of Infogrames SA’s common stock in the Company and reimbursed Infogrames SA for the cost incurred to sell the shares. Finally, on October 21, 2003, the underwriters exercised their over-allotment option, purchasing 3,855,400 shares at a purchase price of $4.25 per share. The option shares were purchased from Infogrames SA, reducing Infogrames SA’s direct and indirect ownership to approximately 67% of the Company. The Company did not receive any of the proceeds from the exercise of the over-allotment option.

Change in Fiscal Year-End

Effective March 28, 2003, the Company changed its fiscal year-end from June 30 to March 31. Accordingly, the fiscal period ended December 31, 2003, represents nine months of operations.

Basis of Presentation

The accompanying interim consolidated financial statements of the Company are unaudited, but in the opinion of management, reflect all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the results for the interim period in accordance with instructions for Form 10-Q. Accordingly, they do not include all information and notes required by generally accepted accounting principles for complete financial statements. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the period ended March 31, 2003. The information for March 31, 2003 was derived from audited financial statements.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All material intercompany transactions and balances have been eliminated.

Revenue Recognition

Revenue is recognized when title and risk of loss transfer to the customer, provided that collection of the resulting receivable is deemed probable by management.

The Company is not contractually obligated to accept returns except for defective product. However, the Company may permit its customers to return or exchange product and provides allowances for estimated returns, price concessions, or other allowances on a negotiated basis. The Company estimates such returns and allowances based upon management’s

Page 9

evaluation of historical experience, market acceptance of products produced, retailer inventory levels, budgeted customer allowances, the nature of the title and existing commitments to customers. Such estimates are deducted from gross sales and provided for at the time revenue is recognized.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Goodwill and Other Intangible Assets

On June 30, 2001, the Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” was issued. SFAS No. 142 eliminates goodwill amortization over its estimated useful life. However, goodwill is subject to at least an annual assessment for impairment by applying a fair-value based test. Additionally, acquired intangible assets are separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented or exchanged, regardless of the Company’s intent to do so. Intangible assets with finite lives are amortized over their useful lives. The Company adopted SFAS No. 142 effective July 1, 2001. Such adoption did not result in an impairment of goodwill, based on an assessment of fair value performed by an independent appraisal company. As of March 31, 2003, the Company has performed its annual fair-value based assessment which did not result in any impairment of goodwill and intangibles. As of December 31, 2003, the Company did not believe that there are any indications of impairment of goodwill and intangibles. However, future changes in the facts and circumstances relating to the Company’s goodwill and other intangible assets could result in an impairment of intangible assets in subsequent periods.

Other intangible assets approximate $2.1 million and $1.6 million, net of accumulated amortization of $0.6 million and $1.1 million at March 31, 2003 and December 31, 2003, respectively.

Fair Values of Financial Instruments

SFAS No. 107, “Disclosure About Fair Value of Financial Instruments”, requires certain disclosures regarding the fair value of financial instruments. Cash, accounts receivable, accounts payable, accrued liabilities, royalties payable, revolving credit facility, related party credit facilities and amounts due to and from related parties are reflected in the consolidated financial statements at fair value because of the short-term maturity of these instruments and that they are principally denominated in US dollars.

Long-Lived Assets

The Company reviews long-lived assets, such as fixed assets to be held, for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. If the estimated fair market value of the asset is less than the carrying amount of the asset plus the cost to dispose, an impairment loss is recognized as the amount by which the carrying amount of the asset plus the cost to dispose exceeds its fair value, as defined in SFAS No. 144, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”.

Research and Development Costs

Research and development costs related to the design, development and testing of new software products are charged to expense as incurred. Research and development costs also include payments for royalty advances (“Milestone Payments”) to third-party developers for products that are currently in development.

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Licenses

Payments made to third parties for licensing intellectual property are capitalized and amortized over projected unit sales. Management evaluates the carrying value of these capitalized licenses and records any impairment in value, if any, as research and development expense.

Income Taxes

The Company accounts for income taxes using the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates in effect for the years in which the differences are expected to reverse. The Company records a valuation to reduce tax assets to a realizable amount. The Company monitors its tax liability on a quarterly basis and records the estimated tax obligation based on the Company’s current year-to-date taxable income.

Net Income (Loss) Per Share Attributable to Common Stockholders

Basic net income (loss) per share attributable to common stockholders is computed by dividing net income or loss attributable to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted net income (loss) per share attributable to common stockholders reflects the potential dilution that could occur from shares of common stock issuable through stock-based compensation plans including stock options, restricted stock awards and warrants using the treasury stock method and other convertible securities. The following is an analysis of the difference between the shares used in basic and diluted net income (loss) per share attributable to common stockholders (in thousands, except per share data):


				Three Months				Nine Months
				Ended				Ended
				December 31,				December 31,
				2002		2003		2002		2003

Basic earnings per share calculation:
	Net income			$	30,054	$	23,019	$	30,076	$	18,079
	Dividend to parent				—		—		—		(39,351	)

	Net income (loss) attributable to common stockholders			$	30,054	$	23,019	$	30,076	$	(21,272	)

	Basic weighted average shares outstanding				69,891		121,170		69,847		88,981
	Basic net income (loss) per share attributable to common stockholders			$	0.43	$	0.19	$	0.43	$	(0.24	)

Diluted earnings per share calculation:
	Net income			$	30,054	$	23,019	$	30,076	$	18,079
		Interest expense: Infogrames SA 0% subordinate convertible note			718		—		2,580		—
			5% subordinated convertible notes		867		—		2,153		—
	Dividend to parent				—		—		—		(39,351	)

	Net income (loss) attributable to common stockholders			$	31,639	$	23,019	$	34,809	$	(21,272	)

Page 11


			Three Months				Nine Months
			Ended				Ended
			December 31,				December 31,
			2002		2003		2002		2003

Weighted average shares outstanding				69,891		121,170		69,847		88,981
	Dilutive potential common shares:
		Infogrames SA 0% subordinate convertible note		7,619		—		7,620		—
		5% subordinated convertible notes		2,500		—		2,500		—
		Employee stock options and warrants		93		155		111		—

Diluted weighted average shares outstanding				80,103		121,325		80,078		88,981

Diluted net income (loss) per share attributable to common stockholders			$	0.39	$	0.19	$	0.43	$	(0.24	)

The number of antidilutive shares that were excluded from the diluted weighted average share calculation for the three months ended December 31, 2003 was approximately 7,034,000 from stock options and warrants in which the exercise price is greater than the average market price of the common shares during the period. The nine months ended December 31, 2003, excludes 16,058,000 antidilutive shares representing all stock options, restricted stock awards and warrants using the treasury stock method and other convertible securities since the nine month results reflect a loss to common stockholders.

The number of antidilutive shares that were excluded from the diluted weighted average share calculation for the three and nine months ended December 31, 2002 was approximately 6,200,000 and 6,180,000, respectively, from stock options and warrants in which the exercise price is greater than the average market price of the common shares during the respective periods.

Stock-Based Compensation

The Company accounts for employee stock option plans under the intrinsic value method proscribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. Any equity instruments issued other than to employees for acquiring goods and services are accounted for using fair value at the date of grant.

In fiscal 2003, the Company adopted the disclosure provisions of Financial Accounting Standards Board (“FASB”) Statement No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an Amendment to FASB Statement No. 123”, which provides alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. The Statement also amends the disclosure requirements of FASB No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the methods used on reported results.

At December 31, 2003, the Company had three stock option plans. No compensation cost is reflected in net income (loss), as all options granted under those plans generally have an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on the net income (loss) and income (loss) per share if the Company had applied the fair value recognition provisions of the FASB Statement No. 123, “Accounting for Stock-Based Compensation”, to stock-based employee compensation (in thousands, except per share data):

Page 12


		Three Months				Nine Months
		Ended				Ended
		December 31,				December 31,
		2002		2003		2002		2003

Net income:
	Basic - as reported	$	30,054	$	23,019	$	30,076	$	18,079
	Less: Fair value of stock-based employee compensation expense, net of related tax effects		1,333		1,668		4,260		4,523

	Basic - pro forma net income		28,721		21,351		25,816		13,556
	Dividend to parent		—		—		—		(39,351	)

	Basic – pro forma net income (loss) attributable to common stockholders	$	28,721	$	21,351	$	25,816	$	(25,795	)

	Diluted - as reported	$	31,639	$	23,019	$	34,809	$	18,079
	Less: Fair value of stock-based employee compensation expense, net of related tax effects		1,333		1,668		4,260		4,523

	Diluted - pro forma net income		30,306		21,351		30,549		13,556
	Dividend to parent		—		—		—		(39,351	)

	Diluted – pro forma net income (loss) attributable to common stockholders	$	30,306	$	21,351	$	30,549	$	(25,795	)

Net income (loss) per share:
	Basic attributable to common stockholders – as reported	$	0.43	$	0.19	$	0.43	$	(0.24	)
	Basic attributable to common stockholders – pro forma	$	0.41	$	0.18	$	0.37	$	(0.29	)
	Diluted attributable to common stockholders - as reported	$	0.39	$	0.19	$	0.43	$	(0.24	)
	Diluted attributable to common stockholders – pro forma	$	0.38	$	0.18	$	0.38	$	(0.29	)

The fair market value of options granted under stock option plans during the three months and nine months ended December 31, 2002 and 2003 was determined using the Black-Scholes option pricing model utilizing the following assumptions:


	Three Months						Nine Months
	Ended						Ended
	December 31,						December 31,
	2002			2003			2002			2003

Dividend yield		0	%		0	%		0	%		0	%
Anticipated volatility		95	%		123	%		95	%		122	%
Weighted average risk-free interest rate		4.51	%		3.00	%		4.51	%		2.78	%
Expected lives		4 years			4 years			4 years			4 years

Page 13

Recent Accounting Pronouncements

In January 2003, the FASB issued FASB Interpretation (“FIN”) No. 46, “Consolidation of Variable Interest Entities”. In December 2003, the FASB issued FIN No. 46 (Revised) (“FIN 46-R”) to address certain FIN 46 implementation issues. This interpretation requires that the assets, liabilities, and results of activities of a Variable Interest Entity (“VIE”) be consolidated into the financial statements of the enterprise that has a controlling interest in the VIE. FIN 46-R also requires additional disclosures by primary beneficiaries and other significant variable interest holders. For entities acquired or created before February 1, 2003, this interpretation is effective no later than the end of the first interim or reporting period ending after March 15, 2004, except for those VIE’s that are considered to be special purpose entities, for which the effective date is no later than the end of the first interim or annual reporting period ending after December 15, 2003. For all entities that were acquired subsequent to January 31, 2003, this interpretation is effective as of the first interim or annual period ending after December 31, 2003. The adoption of the provisions of this interpretation did not have a material effect on the Company’s financial condition or results of operations.

In May 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. This statement amends SFAS No. 133, by requiring that contracts with comparable characteristics be accounted for in a similar fashion. In particular, the Statement: (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative discussed in paragraph 6(b) of Statement 133; (2) clarifies when a derivative contains a financing component; (3) amends the definition of an “underlying” to conform it to language used in FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”; and (4) amends certain other existing pronouncements. This Statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The Company does not have any derivative instruments as defined in SFAS No. 149. Accordingly, this pronouncement is currently not applicable to the Company.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Financial Instruments with the Characteristics of Both Liabilities and Equities”. SFAS No. 150 establishes standards regarding the manner in which an issuer classifies and measures certain types of financial instruments having characteristics of both liabilities and equity. Pursuant to SFAS No. 150, such freestanding financial instruments (i.e., those entered into separately from an entity’s other financial instruments or equity transactions or that are legally detachable and separately exercisable) must be classified as liabilities or, in some cases, assets. In addition, SFAS No. 150 requires that financial instruments containing obligations to repurchase the issuing entity’s equity shares and, under certain circumstances, obligations that are settled by delivery of the issuer’s shares be classified as liabilities. The Statement is effective for financial instruments entered into or modified after May 31, 2003 and for other instruments at the beginning of the first interim period beginning after June 15, 2003. The adoption of this new principle did not have a material impact on the Company’s financial condition or results of operations.

NOTE 2 – SHINY ACQUISITION

On April 30, 2002, the Company acquired all of the outstanding shares of common stock of Shiny Entertainment, Inc. (“Shiny”), a videogame development studio (the “Shiny Acquisition”). Total consideration, including acquisition costs and assumption of employee stock options to purchase shares of common stock of Shiny was approximately $50.8 million. The Shiny Acquisition was accounted for as a purchase. The purchase price was allocated to net assets acquired, in process research and development, other intangible assets and goodwill. Accordingly, $7.4 million of in process research and development was expensed in the year ended June 30, 2002. Furthermore, $2.7 million of the purchase price was allocated to other intangible assets and the balance was allocated to net liabilities and goodwill. Other intangible assets are being amortized over four years.

The purchase price paid by the Company for the shares of Shiny consisted of (i) $31.0 million in cash at closing, (ii) the issuance of short-term promissory notes for an aggregate principal face amount of $16.2 million payable by the Company in installments through July 31, 2002, (iii) $2.0 million paid to third-party licensors, (iv) assumption of employee stock options granted to purchase shares of Shiny valued at $0.7 million and (v) approximately $0.9 million in professional and legal costs. The Company financed the purchase with borrowings from Infogrames SA, under a medium-term loan (Note 8), which guaranteed repayments of the short-term promissory notes. As of December 31, 2003, no amount remained outstanding of the medium-term loan and the loan has been eliminated as part of the Recapitalization Agreement (Notes 1 and 8).

Page 14

NOTE 3 – RECEIVABLES, NET

Receivables consist of the following (in thousands):


	March 31,			December 31,
	2003			2003

Trade accounts receivable	$	87,372		$	151,090
Less: Allowances for bad debts, returns, price protection and other customer promotional programs		(40,319	)		(50,713	)

	$	47,053		$	100,377

NOTE 4 – INVENTORIES, NET

Inventories consist of the following (in thousands):


	March 31,			December 31,
	2003			2003

Finished goods	$	38,721		$	40,481
Return inventory		2,786			3,697
Raw materials		1,223			1,260

		42,730			45,438
Less: Obsolescence reserve		(4,903	)		(2,563	)

	$	37,827		$	42,875

NOTE 5 –RELATED PARTY TRANSACTIONS

Royalty agreement

The Company and Infogrames SA have a distribution agreement in place, which provides for the distribution by the Company of Infogrames SA’s (or any of it subsidiaries) products in the United States, Canada and their territories and possessions, pursuant to which the Company will pay Infogrames SA either 30.0% of the gross profit on such products or 130.0% of the royalty rate due to the developer, whichever is greater. The Company recognizes this amount as royalty expense as part of cost of goods sold. For the three months ended December 31, 2002 and 2003, the Company recorded approximately $17.5 million and $13.7 million, respectively, of royalty expense. For the nine months ended December 31, 2002 and 2003, the Company recorded approximately $29.0 million and $23.3 million, respectively, of royalty expense.

The agreement also includes distribution rights by Infogrames SA of the Company’s products across Europe, pursuant to which Infogrames SA will pay the Company 30.0% of the gross profit on such products or 130.0% of the royalty rate due to the developer, whichever is greater. The Company recognizes this amount as royalty income, included in net revenues. For the three months ended December 31, 2002 and 2003, royalty income earned by the Company based on the agreement amounted to approximately $7.0 million and $10.0 million, respectively. For the nine months ended December 31, 2002 and 2003, royalty income earned by the Company based on the agreement amounted to approximately $17.2 million and $27.3 million, respectively.

Page 15

Advances to Related Parties

Atari Interactive

The GECC Senior Credit Facility allowed the Company to make advances (up to a maximum of $45 million) to Atari Interactive through related party loans. This related party loan bore interest at prime plus 150 basis points and, prior to the Recapitalization Agreement, was repayable from distribution royalties owed by the Company to Atari Interactive in the ordinary course of operations. Additionally, normal trade payables to Atari Interactive were netted against the loan balance outstanding when the invoices became due (generally in 45 days). At March 31, 2003, loans due from Atari Interactive were $30.5 million.

As part of the Recapitalization Agreement, Atari Interactive, Infogrames SA and the Company agreed to offset the amount due from Atari Interactive for advances, loans and current accounts receivable against amounts due under the $50.0 million principal amount of non-interest bearing subordinated convertible notes and the 5% subordinated convertible notes to Infogrames SA. As of September 18, 2003, the Company had approximately $44.7 million due from Atari Interactive that was offset against the balance outstanding of the $50.0 million principal amount of non-interest bearing subordinated convertible notes. There are no advances outstanding as of December 31, 2003. (See Note 1, Recapitalization.) For the nine months ended December 31, 2003, the Company recognized interest income on the advances of approximately $1.1 million, of which no amount remained outstanding at December 31, 2003.

As part of the most recent amendment under the GECC Senior Credit Facility, dated December 23, 2003, the Company no longer makes advances to Atari Interactive.

Atari Australia

The Company’s Australian operations have earned distribution revenues and incurred management fees from Atari Australia, a wholly-owned subsidiary of Infogrames SA. As of March 31, 2003, the Company had approximately $1.7 million outstanding from Atari Australia.

As part of the Recapitalization Agreement, Infogrames SA and the Company agreed to offset the outstanding receivable balance owed from Atari Australia against amounts due under the $50.0 million principal amount of non-interest bearing subordinated convertible notes and the 5% subordinated convertible notes owed to Infogrames SA. As of September 18, 2003, the Company had approximately $1.9 million outstanding from Atari Australia that was offset against the outstanding balance of the $50.0 million principal amount of non-interest bearing subordinated convertible notes and the 5% subordinated convertible notes. No balance remains outstanding as of December 31, 2003. (See Note 1, Recapitalization.)

Gain on sale of development project to a related party

During the third quarter of fiscal 2004, the Company sold a development project to Atari Interactive for $3.7 million resulting in a gain of an equal amount. The project involved a license owned by Atari Interactive for which development rights were transferred to the Company in the fourth quarter of fiscal 2003 at no cost to the Company. Management believes that the value of the development rights was minimal at the time of the transfer. The sales price to Atari Interactive was equal to the development costs incurred by the Company which were expensed during the period of development, principally in the first six months of fiscal 2004. The sale was initiated as a result of concerns expressed by the original third party licensor relating to the Company’s development efforts.

Please see the Related Party Transactions disclosure in the Company’s Registration Statement on Form S-2 on file with the Securities and Exchange Commission for a description of all material related party transactions.

Page 16

NOTE 6 – ACCRUED LIABILITIES

Accrued liabilities consist of the following (in thousands):


	March 31,		December 31,
	2003		2003

Accrued advertising	$	1,769	$	14,633
Accrued professional fees and other services		1,696		2,009
Accrued salary and related costs		8,944		4,034
Accrued freight and processing fees		1,207		1,890
Accrued third-party development expenses		4,826		4,345
Accrued distribution services		8,134		3,737
Other		5,296		4,410

	$	31,872	$	35,058

NOTE 7 – COMMITMENTS AND CONTINGENCIES

Litigation

During the nine months ended December 31, 2003, no significant claims were asserted against or by the Company that in management’s opinion the likely resolution of which would have a material adverse affect on the Company’s liquidity, financial condition or results of operations, although the Company is involved in various legal actions arising in the ordinary course of business. The following litigation matters are still pending or were terminated during the period. The Company continues to believe that, with respective to pending matters, the underlying complaints are without merit and intends to defend itself vigorously against these actions.

The Company’s management believes that the ultimate resolution of any of the actions summarized below or any other actions which are not specifically described herein will not have a material adverse effect on the Company’s liquidity, financial condition or results of operations.

KBK

On September 16, 2002, Knight Bridging Korea Co. Ltd. (“KBK”), a distributor of electronic games via the Internet and local area networks, filed a lawsuit against Gamesonline.com, Inc. (“Gamesonline”), a subsidiary of Interplay Entertainment Corp. (“Interplay”), and the Company in Superior Court of California, Orange County. KBK alleges that on or about December 15, 2001, KBK entered into a contract with Gamesonline to obtain the right to localize (i.e., right to translate games into the local language of the country where the games are distributed) and to electronically distribute in Korea, Neverwinter Nights and certain other games which were previously released. The complaint further alleges that Gamesonline and the Company conspired to prevent KBK from entering the market with Neverwinter Nights or any previously released games of Gamesonline. The complaint alleges the following causes of action against the Company: misappropriation of trade secrets under the California Uniform Trade Secrets Act; common law misappropriation; intentional interference with contract; negligent interference with contract; intentional interference with prospective economic advantage; negligent interference with prospective economic advantage; and violation of Business & Professions Code Section 17200 et seq. The complaint seeks $98.8 million for each of these causes of action.

An amended complaint was filed on December 3, 2002, alleging all of the foregoing against the Company, adding Atari Interactive (formerly known as Infogrames Interactive, Inc.) as a named defendant, and alleging that the Company managed and directed Atari Interactive to engage in the foregoing alleged acts. The Company and Atari Interactive filed answers on January 9, 2003. On or about January 28, 2003, Gamesonline answered the original complaint and served a cross-complaint against KBK. On April 29, 2003, KBK named as defendants “Infogrames Asia Pacific”, “Infogrames Korea”, and “Interplay, Inc.”. On October 29, 2003, Interplay filed a cross-complaint against the Company, Atari Interactive,

Page 17

Inc., Infogrames Korea and Roes 101 through 200. The Company and Atari Interactive filed an answer on December 3, 2003. Discovery is ongoing.

Interplay

On September 19, 2003, Interplay, commenced a wrongful termination and breach of contract action (the “Action”) in New York State Supreme Court, New York County in which it named Atari Interactive and the Company as defendants, seeking, among other things, a judgment declaring that a computer game license agreement between Interplay and Atari Interactive continues to be in full force and effect.

On September 23, 2003, Interplay obtained a preliminary injunction that prevents termination of the computer game license agreement. On October 9, 2003, Atari Interactive answered the complaint, denying all claims, asserting several affirmative defenses and counterclaims for breach of contract and one counterclaim for a judgment declaring the computer game license agreement terminated. Atari Interactive’s answer also asserted that the Company was incorrectly named as the defendant in this Action. Both sides sought damages in an amount to be determined at trial.

The Company, Atari Interactive and Interplay reached an agreement with respect to the scope and terms of the computer game license agreement and accordingly, filed with the court a Stipulation of Dismissal, dated December 22, 2003. The court ordered dismissal of the matter on January 6, 2004.

NOTE 8 – DEBT

Credit Facilities

GECC Senior Credit Facility

On November 12, 2002 (last amended December 23, 2003), the Company obtained a 30-month $50.0 million Senior Credit Facility with GECC to fund the Company’s working capital and general corporate needs, as well as to fund advances to Paradigm Entertainment Inc. (“Paradigm”) and Atari Interactive, each a related party. Loans under the Senior Credit Facility are based on a borrowing base comprised of the value of the Company’s accounts receivable and short term marketable securities. The Senior Credit Facility bears interest at prime plus 1.25% for daily borrowings or LIBOR plus 3% for borrowings with a maturity of 30 days or greater. A commitment fee of 0.5% on the average unused portion of the facility is payable monthly and the Company paid $0.6 million as an initial commitment fee at closing. The Senior Credit Facility contained certain financial covenants and named certain related entities, such as Atari Interactive and Paradigm, as guarantors. In addition, amounts outstanding under the Senior Credit Facility are secured by the Company’s assets. At December 31, 2003, $6.9 million of borrowings remained outstanding and $12.5 million of letters of credit were outstanding. As of December 31, 2003, accrued interest was $0.1 million and included in accrued liabilities. At December 31, 2003, the Company was in compliance with all financial covenants.

As part of the most recent amendment under the Senior Credit Facility, dated December 23, 2003, Atari Interactive and Paradigm have been removed as guarantors. Furthermore, under this amendment, the Company will no longer fund advances to Atari Interactive and Paradigm through related party loans.

Infogrames SA credit facilities and debt with the Company

Credit Agreement

The Company maintained a revolving credit agreement with Infogrames SA (the “Credit Agreement”) which provided for an aggregate commitment of $75.0 million which bore interest at LIBOR plus 2.5%. Effective December 31, 2002, the maturity date of the Credit Agreement was extended to April 1, 2004. This agreement required that the Company comply with certain financial covenants and, among other items, restricted capital expenditures. As of September 30, 2003, all outstanding borrowings were exchanged for 10,541,105 newly issued common shares under the terms of the Recapitalization Agreement. As of December 31, 2003, accrued interest and fees that remain outstanding were minimal and are included in current amounts due to related parties. (See Note 1, Recapitalization.)

Page 18

Medium-Term Loan

In connection with the Shiny Acquisition, the Company obtained a $50.0 million medium-term loan from Infogrames SA. Interest was based on the three month LIBOR rate plus 2.75% and payable on a quarterly basis, in arrears. An unused commitment fee of 0.50% per annum was based on the aggregate amount of the facility less outstanding loans. As of September 30, 2003, all outstanding borrowings have been exchanged for 11,359,319 newly issued common shares under the terms of the Recapitalization Agreement. Additionally, as of December 31, 2003, accrued interest that remained outstanding was minimal and included in current amounts due to related parties. (See Note 1, Recapitalization.)

Long-Term Related Party Debt

0% Notes

In conjunction with the 1999 purchase of the Company by Infogrames SA, the Company issued to General Atlantic Partners, LLC (“GAP”) the $50.0 million principal amount of non-interest bearing subordinated convertible notes (“0% Notes”) in exchange for 600,000 shares of Series A Preferred Stock and $20.0 million of subordinated notes of the Company. The 0% Notes mature in December 2004 and had a redemption value of $50.0 million at maturity. In lieu of payment at maturity, the 0% Notes were convertible at any time, at the holder’s option, into shares of the Company’s common stock at $20.00 per share. On December 28, 2001, Infogrames SA assumed the 0% Notes from GAP in exchange for shares of Infogrames SA common stock. Infogrames SA did not change any of the terms of the 0% Notes (renamed the “Infogrames SA 0% subordinated convertible note”) as they relate to the Company. Interest on the Infogrames SA 0% subordinated convertible note was accreted at the rate of 7% per annum.

Under the terms of the September 4, 2003 Recapitalization Agreement, the Infogrames SA 0% subordinated convertible note has been fully offset against the advances to related parties (Notes 1 and 5).

5% Notes

In conjunction with the 1999 purchase of the Company by Infogrames SA, the Company issued to CUSH, 5% subordinated convertible notes (“5% CUSH Notes”) in exchange for $25.0 million in cash and $35.6 million in debt and accrued interest. The 5% CUSH Notes matured in December 2004 and have a principal amount of $60.6 million. In lieu of payment at maturity, the 5% CUSH Notes were convertible at any time, at the holder’s option, into shares of the Company’s common stock at $9.25 per share.

Under the terms of the September 4, 2003 Recapitalization Agreement, the 5% CUSH Notes, net of the remaining advances to related parties, have been fully converted to 17,129,453 of the Company’s newly issued common shares at a fair-market value of $4.25 per share. The common shares issued by the Company were at a more favorable rate than that available under the original terms of the 5% CUSH Notes. The resulting incremental value of the additional stock issued was recorded as a dividend to Infogrames SA of $39.4 million (Notes 1 and 5).

In September 2003, the Company expensed the full $1.3 million of remaining deferred financing fees related to the Infogrames SA 0% subordinated convertible note and the 5% CUSH Notes as a result of the Recapitalization Agreement.

NOTE 9 – OPERATIONS BY REPORTABLE SEGMENTS

The Company has three reportable segments: publishing, distribution and corporate. Publishing is comprised principally of three studios located in Santa Monica, California; Beverly, Massachusetts; and Minneapolis, Minnesota. Distribution constitutes the sale of other publishers’ titles to various mass merchants and other retailers. Corporate includes the costs of senior executive management, legal, finance, and administration. The majority of depreciation expense for fixed assets is charged to the Corporate segment and a portion is recorded to the publishing segment. This amount consists of depreciation on computers and office furniture at the publishing unit offices. Historically, the Company does not separately track or maintain records, other than fixed asset records, which identify assets by segment and, accordingly, such information is not available.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on operating results of these segments.

Page 19

The Company’s reportable segments are strategic business units with different associated costs and profit margins. They are managed separately because each business unit requires different planning, merchandising and marketing strategies.

The following unaudited summary represents the consolidated net revenues, operating income (loss), depreciation and amortization and interest by reportable segment for the three months and nine months ended December 31, 2002 and 2003 (in thousands):


		Publishing			Distribution			Corporate			Total

Three months ended December 31, 2002:
	Net revenues	$	179,792		$	30,802		$	—		$	210,594
	Operating income (loss)		36,564			8,050			(10,942	)		33,672
	Depreciation and amortization		(907	)		(144	)		(805	)		(1,856	)
	Interest, net		—			19			(3,375	)		(3,356	)
Three months ended December 31, 2003:
	Net revenues	$	174,368		$	16,239		$	—		$	190,607
	Operating income (loss)		28,729			2,906			(6,202	)		25,433
	Depreciation and amortization		(1,001	)		(2	)		(1,808	)		(2,811	)
	Interest, net		—			1			(454	)		(453	)
Nine months ended December 31, 2002:
	Net revenues	$	371,733		$	77,831		$	—		$	449,564
	Operating income (loss)		51,779			16,533			(22,547	)		45,765
	Depreciation and amortization		(2,920	)		(430	)		(2,500	)		(5,850	)
	Interest, net		(57	)		65			(10,686	)		(10,678	)
Nine months ended December 31, 2003:
	Net revenues	$	354,976		$	47,564		$	—		$	402,540
	Operating income (loss)		38,841			8,699			(19,886	)		27,654
	Depreciation and amortization		(2,916	)		(185	)		(3,656	)		(6,757	)
	Interest, net		—			22			(7,237	)		(7,215	)

NOTE 10 – ODDWORLD TRANSACTION

On December 19, 2003, the Company and Oddworld Inhabitants, Inc. (“Oddworld”), a developer, entered into a Settlement and Release Agreement (“Oddworld Agreement”), which provided for, among other things, the exchange of the Company’s licensed publishing rights and preferred stock investment (carried at $3.5 million) in the developer in return for a release of Oddworld’s interest in $1.8 million in publishing royalties previously advanced to the Company by Microsoft Corporation (“Microsoft”).

As part of the transaction, the Company amended its existing Microsoft/Oddworld License Agreement, which, among other things, provides that the Company retain, without any ongoing obligations, $3.5 million of non-refundable publishing royalties previously advanced by Microsoft. This amount is included in net revenues. The foregoing transactions resulted in the recognition of $3.5 million of royalties which were previously deferred and an impairment charge on the disposition of the Company’s preferred stock investment in Oddworld of $1.7 million. The charge is included in Other Income (Expense) in the accompanying Consolidated Statement of Operations.

Page 20

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

This document includes statements that may constitute forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company cautions readers regarding certain forward-looking statements in this document, press releases, securities filings, and all other documents and communications. All statements, other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. The words “believe”, “expect”, “anticipate”, “intend” and similar expressions generally identify forward-looking statements. While the Company believes in the veracity of all statements made herein, forward-looking statements are necessarily based upon a number of estimates and assumptions that, while considered reasonable by the Company, are inherently subject to significant business, economic and competitive uncertainties and contingencies and known and unknown risks. As a result of such risks, the Company’s actual results could differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. The Company will not necessarily update information if any forward-looking statement later turns out to be inaccurate. Some of the factors that could cause actual results or future events to differ materially or otherwise, include the following: the loss of key customers; delays in product development and related product release schedules; maintaining relationships with leading independent video game software developers; adapting to the rapidly changing industry technology; maintaining or acquiring licenses to intellectual property; the termination or modification of our agreements with hardware manufacturers; an inability to maintain or find debt financing on terms commercially reasonable to the Company; and pricing of and demand for distributed products. Please see the “Risk Factors” in the Company’s Registration Statement on Form S-2 on file with the Securities and Exchange Commission for a description of some, but not all, risks, uncertainties and contingencies.

Overview

Business and Operating Segments

The Company is a leading global publisher and developer of video game software for both gaming enthusiasts and the mass-market audience.

Development, publishing and distribution of video game software are the Company’s major activities. Development activities include development of games by both internal and external development studios. Internal studios are studios owned by the Company for the sole purpose of game development and external development studios are independent studios with which the Company or Infogrames SA and its subsidiaries have contracts for the development of specific titles. The Company’s publishing activities include overseeing development, sales, marketing and packaging of video game software. Distribution activities primarily include the sale of games produced by other publishers (“Third-Party Products”).

The distribution channels for interactive software have expanded significantly in recent years. Consumers have access to interactive software through a variety of outlets, including mass-merchant retailers such as Wal-Mart and Target; major retailers, such as Best Buy, CompUSA, and Toys ‘R’ Us; and specialty stores such as Electronics Boutique and GameStop. Additionally, the Company’s games are made available through various Internet and on-line networks. The Company’s sales to key customers Wal-Mart, Best Buy, and Target accounted for approximately 23.5%, 11.2%, and 10.3%, respectively, of net revenues for the nine months ended December 31, 2003.

Key Challenges

The video game software industry has experienced an increased rate of change and complexity in the technological innovations of video game hardware and software. In addition to these technological innovations, there has been greater competition for shelf space and creative talent as well as increased buyer selectivity. As a result, the video game industry has become increasingly hit-driven, which has led to higher per game production budgets, longer and more complex development processes, and generally shorter product life cycles. The importance of the timely release of hit titles, as well as the increased scope and complexity of the product development process, have increased the need for disciplined product development processes that limit cost and overruns. This, in turn, has increased the importance of leveraging the technologies, characters or storylines of existing hit titles into additional video game software franchises in order to spread development costs among multiple products. In this environment, the Company is determined to achieve balances between internal and external development, and licensed and proprietary products.

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Key Developments

Recapitalization and Offering

During the second quarter of fiscal 2004, the Company completed a recapitalization through the issuance of new shares pursuant to an agreement with its majority stockholder, Infogrames SA and a public offering. Per the agreement with Infogrames SA, on September 18, 2003, the Company, among other things, issued an aggregate of 39,029,877 shares of its common stock, valued at $4.25 per share, to Infogrames SA and it’s wholly-owned subsidiary CUSH, in satisfaction of approximately $165.9 million of the Company’s net indebtedness to Infogrames SA. On September 24, 2003, Infogrames SA sold 17,179,412 of such shares at $4.25 per share in a public offering. The Company also sold 9,820,588 new shares of its common stock in the public offering at $4.25 per share, generating net proceeds to the Company of approximately $34.9 million.

After these transactions and the exercise of the underwriter’s over-allotment option on October 21, 2003, Infogrames SA owns approximately 67% of the Company directly and through its wholly-owned subsidiaries CUSH and Atari Interactive.

Atari License

Critical Accounting Policies

The Company’s discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to accounts and notes receivable, inventories, intangible assets, investments, income taxes and contingencies. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ materially from these estimates under different assumptions or conditions.

The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Sales returns, price protection, other customer related allowances and allowance for doubtful accounts

Sales are recorded net of estimated future returns, price protection and other customer related allowances. The Company is not contractually obligated to accept returns; however, based on facts and circumstances at the time a customer may request approval for a return, the Company may permit the return or exchange of products sold to certain customers. In addition, the Company may provide price protection, co-operative advertising and other allowances to certain customers in accordance with industry practice. These reserves are determined based on historical experience, market acceptance of products produced, budgeted customer allowances and existing commitments to customers. Although management believes it provides adequate reserves with respect to these items, actual activity could vary from management’s estimates and such variances could have a material impact on reported results.

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The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make payments when due or within a reasonable period of time thereafter. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make required payments, additional allowances may be required.

For the three months ended December 31, 2002 and 2003, the Company recorded allowances for bad debts, returns, price protection and other customer promotional programs of approximately $41.6 million and $36.3 million, respectively. For the nine months ended December 31, 2002 and 2003, the Company recorded allowances for bad debts, returns, price protection and other customer promotional programs of approximately $91.3 million and $87.2 million, respectively. As of March 31, 2003 and December 31, 2003, the aggregate reserves against accounts receivables for bad debts, returns, price protection and other customer promotional programs were approximately $40.3 million and $50.7 million, respectively.

Inventories

The Company writes down its inventories for estimated slow-moving or obsolete inventories equal to the difference between the cost of inventories and estimated market value based upon assumed market conditions. If actual market conditions are less favorable than those assumed by management, additional inventory write-downs may be required. For the three months ended December 31, 2002 and 2003, the Company recorded obsolescence expense of approximately $0.9 million and $0.3 million, respectively. For the nine months ended December 31, 2002 and 2003, the Company recorded obsolescence expense of approximately $3.1 million and $0.9 million, respectively. As of March 31, 2003 and December 31, 2003, the aggregate reserve against inventories was approximately $4.9 million and $2.6 million, respectively.

External developer royalty advances and milestone payments

Rapid technological innovation, shelf-space competition, shorter product life cycles and buyer selectivity have made it extremely difficult to determine the likelihood of individual product acceptance and success. As a result, the Company follows the policy of expensing external developer royalty advances (also known as developer advances) as incurred, treating such costs as research and development expenses. Generally, developers are paid an advance upon the signing of a contract with the Company. Subsequent payments are due as the specific contractual milestones are met by the developer and approved by the Company. The timing of when these contracts are entered into and when milestone payments are made could vary significantly from budgeted amounts and, because these payments are expensed as incurred, they could have a material impact on reported results in a given period.

Income taxes

As part of the process of preparing the Company’s consolidated financial statements, the Company is required to estimate it’s income taxes in each of the jurisdictions in which it operates. This process involves estimating the Company’s current tax exposures in each jurisdiction including the impact, if any, of additional taxes resulting from tax examinations as well as making judgments regarding the recoverability of deferred tax assets. To the extent recovery of deferred tax assets is not likely based on the Company’s estimation of future taxable income in each jurisdiction, a valuation allowance is established. The estimated effective tax rate is adjusted for the tax related to significant unusual items. Changes in the geographic mix or estimated level of annual pre-tax income can affect the overall effective tax rate.

As of December 31, 2003, the Company has combined net operating loss carryforwards of approximately $427.8 million for federal tax purposes. These loss carryforwards are available to offset future taxable income, if any, and will expire beginning in the years 2011 through 2022. In addition, the amount and expiration of net operation loss carryforwards may differ for state tax purposes. The Company experienced an ownership change in 1999 as a result of its acquisition by Infogrames SA. Under Section 382 of the Internal Revenue Code, when there is an ownership change, the pre-ownership-change loss carryforwards are subject to an annual limitation which could reduce or defer the utilization of these losses. Pre-acquisition losses of approximately $203.3 million are subject to an annual limitation (approximately $7.2 million). A full valuation allowance has been recorded against the net deferred tax asset based on the Company’s historical operating results and the conclusion that such asset may not be realized. Management reassesses its position with regard to the valuation allowance on a quarterly basis.

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Related Party Transactions

The Company is involved in numerous related party transactions with Infogrames SA and its subsidiaries. These related party transactions include, but are not limited to the purchase and sale of product, game development, management and support services and royalty agreements. For a description of all material related party transactions, please see the Company’s Registration Statement on Form S-2.

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Results of Operations

Three months ended December 31, 2003 versus the three months ended December 31, 2002

Consolidated Statement of Operations (dollars in thousands):


		Three					Three
		Months		% of			Months			% of
		Ended		Net			Ended			Net			Increase/
		December 31,		Revenues			December 31,			Revenues			(Decrease)

		2002		2002			2003			2003

Net revenues		$	210,594		100.0	%	$	190,607			100.0	%	$	(19,987	)
Cost of goods sold			104,142		49.5	%		93,916			49.3	%		(10,226	)

	Gross profit		106,452		50.5	%		96,691			50.7	%		(9,761	)
Selling and distribution expenses			39,758		18.9	%		37,339			19.6	%		(2,419	)
General and administrative expenses			14,190		6.6	%		7,924			4.2	%		(6,266	)
Research and development			16,976		8.1	%		26,928			14.1	%		9,952
Gain on sale of development project to a related party			—		0.0	%		(3,744	)		(2.0	%)		3,744
Depreciation and amortization			1,856		0.9	%		2,811			1.5	%		955

	Operating income		33,672		16.0	%		25,433			13.3	%		(8,239	)
Interest expense, net			3,356		1.6	%		453			0.2	%		(2,903	)
Other income (expense)			220		0.1	%		(1,880	)		(1.0	%)		(2,100	)

	Income before provision for income taxes		30,536		14.5	%		23,100			12.1	%		(7,436	)
Provision for income taxes			482		0.2	%		81			0.0	%		(401	)

	Net income		30,054		14.3	%		23,019			12.1	%		(7,035	)
Dividend to parent			—		0.0	%		—			0.0	%		—

	Net income attributable to common stockholders	$	30,054		14.3	%	$	23,019			12.1	%	$	(7,035	)

Net Revenues

Net Revenues by Segment (in thousands):


	Publishing		Distribution		Corporate		Total

Three months ended December 31, 2002	$	179,792	$	30,802	$	—	$	210,594
Three months ended December 31, 2003	$	174,368	$	16,239	$	—	$	190,607

Net revenues for the three months ended December 31, 2003 decreased $20.0 million or 9.5% from $210.6 million to $190.6 million primarily due to:

• The Company’s publishing business experienced a 3.0% decline in publishing net revenues to $174.4 million from $179.8 million in the December 2002 quarter because of lower replenishment orders over the holiday season. Top sellers in the current quarter include titles from the Dragon Ball Z franchise (DBZ: Budokai 2 (Playstation2), DBZ: Budokai Greatest Hits (Playstation2) and DBZ: Taiketsu (Gameboy Advance)) as well as new releases Yu Yu Hakusho: Spirit Detective (Gameboy Advance), Backyard Basketball (Playstation2), Terminator 3: Rise of the Machines (Playstation 2 and Xbox), Mission Impossible — Operation Surma (Playstation 2 and Xbox), and Beyblades: Ultimate Blader Jam (GBA).

• Publishing net revenues in the 2003 period include nearly $10.0 million in royalty income earned from the sale of US product in Europe, while the December 2002 period included $7.0 million in similar royalty income. Approximately $1.7 million of the $3.0 million increase is a benefit of the weakening dollar on revenues earned in euros. The remainder of the increase is from strong international sales of December 2003 quarter releases, mainly of

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Mission Impossible-Operation Surma (Playstation2 and Xbox) and Terminator 3: Rise of the Machines (Playstation2 and Xbox), than of December 2002 quarter releases.

• Additionally, the Company recognized $3.5 million of previously deferred revenue from sublicensing income as a result of a termination of its sublicensing arrangement with Microsoft. See Note 10 of the Notes of these Consolidated Financial Statements for additional information related to this transaction.

• Distribution net revenues decreased from $30.8 million to $16.2 million due primarily to the Company’s decision to reduce its third party distribution operations in the specific instances where margins are considered insufficient.

Gross Profit


	Publishing Platform Mix

	2002			2003

PC		42.5	%		27.9	%
Playstation2		26.0	%		40.4	%
Xbox		11.6	%		8.7	%
Game Cube		9.0	%		5.1	%
Gameboy Advanced		6.0	%		16.5	%
Playstation		2.7	%		1.3	%
Gameboy Color		2.2	%		0.1	%

Total		100.0	%		100.0	%

Gross profit decreased to $96.7 million for the three months ended December 31, 2003 from $106.5 million in the comparable 2002 period primarily from decreased sales volume, while as a percentage of net revenues, gross profit of 50.7% is in line with December 2002’s rate of 50.5%. The benefit of a sales mix shift out of the higher cost distribution business and into the lower cost publishing business is largely being offset by a continuing sales mix shift within the publishing business toward the more costly console product and away from the less costly PC product, which is consistent with current industry trends. Approximately 72.1% of the publishing business shipments were console sales during the three months ended December 31, 2003, versus 57.5% in the comparable 2002 period. For the three months ended December 31, 2003, the distribution business accounted for 8.5% of the Company’s net revenues as compared to 14.6% for the comparable 2002 period.

Selling and Distribution Expenses`

Selling and distribution expenses primarily include shipping, personnel, advertising, promotions and distribution expenses. During the three months ended December 31, 2003, selling and distribution expenses decreased approximately $2.5 million, or 6.3%, to $37.3 million from $39.8 million in the comparable 2002 period due to lower advertising expense from fewer new product releases as well as lower variable costs (mainly freight and handling) from decreased net revenues. Advertising expenses decreased approximately $2.5 million or 8.0% as compared to the three months ended December 31, 2002. Freight expenses were reduced by approximately $0.8 million as compared to the 2002 period. Variable selling and distribution costs as a percentage of net revenues remained consistent from the prior December 2002 period as fixed costs have generally been reduced in line with lower net revenues.

General and Administrative Expenses

General and administrative expenses primarily include personnel expenses, facilities costs, professional expenses and other overhead charges. These expenses for the three months ended December 31, 2003 and 2002 decreased $6.3 million, or 44.4%, to $7.9 million from $14.2 million mainly because the December 2002 bonus expense included a charge for one-time incentive compensation. Slightly offsetting the decreased bonus expense is a $0.9 million bad debt charge in the current quarter related to the recent KB Toys Inc. bankruptcy filing; the December 2002 quarter included a $0.3 million charge for that quarter’s FAO Inc. bankruptcy filing. Without the one-time incentive compensation from the 2002 period, general and

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administrative expenses as a percentage of net revenues of 6.6% would have been reduced to 4.7% in the 2002 period, consistent with the 2003 percentage of 4.2%.

Research and Development Expenses

Research and development expenses primarily include the payment of royalty advances to third-party developers on products that are currently in development and direct costs of internally developing and producing a title. These expenses for the three months ended December 31, 2003 increased approximately $9.9 million, or 58.2%, to $26.9 million from $17.0 million in the comparable 2002 period, primarily from the increase of approximately $7.0 million in amortization and write-off of capitalized licenses and the timing of milestone completions. In relation to total research and development expenses, the internal costs without license amortization and write-off represented 45.9% of the total research and development costs for the three months ended December 31, 2003, while internal costs were 59.3% of total research and development costs for the comparable 2002 period.

Gain on Sale of a Development Project to a Related Party

Depreciation and Amortization

Depreciation and amortization for the three months ended December 31, 2003 increased by $0.9 million, or 47.4%, to $2.8 million from $1.9 million in the comparable 2002 period, due to amortization expense of the Company’s license with Atari Interactive for the rights to the Atari name.

Interest Expense, net

Interest expense, net, decreased approximately $2.9 million to $0.5 million for the three months ended December 31, 2003 from $3.4 million in the comparable 2002 period. The decrease is a result of the Company’s September 2003 recapitalization whereby all outstanding related party debt was converted to equity. Since the recapitalization, interest and financing fees have consisted primarily of expenses incurred under the Company’s credit facility arrangement with GECC. Interest income generated from the proceeds of the Company’s secondary equity offering was minimal and is netted against the current quarter’s interest expense.

Other Income (Expense)

Other income (expense) includes a $1.7 million write-down related to the Oddworld transaction (see Note 10 of the Notes of these Consolidated Financial Statements for additional information related to this transaction).

Provision for Income Taxes

During the three months ended December 31, 2002, the Company recorded Federal Alterative Minimum Tax of approximately $0.4 million. During the three months ended December 31, 2003, a nominal provision was recorded for miscellaneous state and foreign taxes paid based on the overall expected tax rate for the fiscal year.

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Nine months ended December 31, 2003 versus the nine months ended December 31, 2002

Consolidated Statement of Operations (dollars in thousands):


		Nine						Nine
		Months			% of			Months			% of
		Ended			Net			Ended			Net			Increase/
		December 31,			Revenues			December 31,			Revenues			(Decrease)

		2002			2002			2003			2003

Net revenues		$	449,564			100.0	%	$	402,540			100.0	%		(47,024	)
Cost of goods sold			218,062			48.5	%		202,712			50.4	%		(15,350	)

	Gross profit		231,502			51.5	%		199,828			49.6	%		(31,674	)
Selling and distribution expenses			81,122			18.0	%		71,270			17.7	%		(9,852	)
General and administrative expenses			30,904			7.0	%		25,157			6.1	%		(5,747	)
In-process research and development			7,400			1.6	%		—			—			(7,400	)
Research and development			60,461			13.4	%		72,734			18.1	%		12,273
	Gain on sale of development project to a related party		—			—			(3,744	)		(0.9	%)		3,744
Depreciation and amortization			5,850			1.3	%		6,757			1.7	%		907

	Operating income		45,765			10.2	%		27,654			6.9	%		(18,111	)
Interest expense, net			10,678			2.4	%		7,215			1.8	%		(3,463	)
Other expense			(2,844	)		(0.6	%)		(2,297	)		(0.6	%)		(547	)

	Income before provision for income taxes		32,243			7.2	%		18,142			4.5	%		(14,101	)
Provision for income taxes			2,167			0.5	%		63			—			(2,104	)

	Net income		30,076			6.7	%		18,079			4.5	%		(11,997	)
Dividend to parent			—			0.0	%		(39,351	)		(9.8	%)		39,351

	Net income (loss) attributable to common stockholders	$	30,076			6.7	%	$	(21,272	)		(5.3	%)	$	(51,348	)

Net Revenues

Net Revenues by Segment (in thousands):


	Publishing		Distribution		Corporate		Total

Nine months ended December 31, 2002	$	371,733	$	77,831	$	—	$	449,564
Nine months ended December 31, 2003	$	354,976	$	47,564	$	—	$	402,540

Net revenues for the nine months ended December 31, 2003 decreased approximately $47.1 million or 10.5% from $449.6 million to $402.5 million.

• A 4.5% decline in publishing net revenues from $371.7 million in the December 2002 period to $355.0 million in the December 2003 period is the combined result of reduced replenishment orders in the current quarter and a light schedule of new product releases in the prior (September 2003) quarter, partially offset by stronger international royalty income earned on Infogrames SA’s international sales of the Company’s titles in the current year.

• Publishing revenues include international royalty income earned on Infogrames SA’s international sales of the Company’s titles which is up by $10.1 million from $17.2 million in 2002 to $27.3 million in 2003. The increase includes a favorable exchange rate impact in the current fiscal year of approximately $4.2 million from the weakening US dollar against the euro and strong fiscal 2004 international sales of Enter the Matrix (Playstation2, Xbox, PC and GameCube).

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• Additionally, the Company recognized $3.5 million of previously deferred revenue from sublicensing income of as a result of a termination of its sublicensing arrangement with Microsoft. See Note 10 of the Notes of these Consolidated Financial Statements for additional information related to this transaction.

• Total distribution net revenues decreased 39.0% from $77.9 million to $47.5 million from continued general industry softness in productivity software and the Company’s decision to reduce its third party distribution operations in the specific instances where margins are considered insufficient.

Gross Profit


	Publishing Platform Mix

	2002			2003

PC		38.6	%		27.4	%
Playstation2		31.1	%		36.1	%
Xbox		10.2	%		13.3	%
Gameboy Advanced		11.2	%		12.7	%
Game Cube		4.5	%		7.4	%
Playstation		3.2	%		2.9	%
Gameboy Color		1.1	%		0.2	%
Other		0.1	%		0.0	%

Total		100.0	%		100.0	%

Gross profit decreased to $199.8 million for the nine months ended December 31, 2003 from $231.5 million in the comparable 2002 period primarily from decreased sales volume, while, as a percentage of net revenues, gross profit decreased from 51.5% to 49.6%. The benefit of a sales mix shift out of the higher cost distribution business and into the lower cost publishing business is largely being offset by a continuing sales mix shift within the publishing business toward the more costly console product and away from the less costly PC product, which is consistent with current industry trends. Approximately 72.6% of the publishing businesses shipments were console sales during the nine months ended December 31, 2003 versus 61.4% in the comparable 2002 period. For the nine months ended December 31, 2003, the distribution business accounted for 11.8% of the Company’s net revenues as compared to 17.3% for the comparable 2002 period. Finally, a higher mix of royalty-bearing products sold in the current period contributed to lower margins. In the nine month period ended December 2003, royalty expense included in cost of goods sold was 15.4% of net revenues while, in the 2002 period, royalty expense was 12.6% of net revenues.

Selling and Distribution Expenses

During the nine months ended December 31, 2003, selling and distribution expenses decreased approximately $9.8 million, or 12.1%, to $71.3 million from $81.1 million in the comparable 2002 period due to lower advertising expense from fewer new product releases as well as lower variable costs (mainly freight and handling) from decreased net revenues. Advertising expenses decreased $4.6 million or 8.8% and variable freight and distribution expenses decreased $2.9 million from the comparable 2002 period. The selling and distribution expenses remained relatively unchanged as a percentage of net revenues at 17.7% for the nine months ended December 31, 2003 from 18.0% in the comparable 2002.

General and Administrative Expenses

The general and administrative expenses of $25.2 million are significantly below the December 2002 period’s expenses of $30.9 million mainly because the December 2002 bonus expense included a charge for one-time incentive compensation. Slightly offsetting the decreased bonus expense is a $0.9 million bad debt charge in the current period related to the recent KB Toys Inc. bankruptcy filing; the December 2002 period included a $0.3 million charge for that period’s FAO Inc. bankruptcy filing. Without the one-time incentive compensation from the 2002 period, general and administrative expense as a percentage of net revenues of 7.0% would have been reduced to 6.0% in the 2002 period, consistent with the 2003 percentage of 6.1%.

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In-Process Research and Development Expense

The $7.4 million of in-process research and development expense in the December 2002 period represents a portion of the purchase price paid for the Shiny development studio during that period. No such expense was recorded in the current period.

Research and Development Expenses

Research and development expenses for the nine months ended December 31, 2003 increased approximately $12.2 million, or 20.2%, to $72.7 million from $60.5 million in the comparable 2002 period, primarily from the increase of approximately $7.2 million in amortization and write-off of capitalized licenses and the timing of milestone completions upon which this expense is based. In relation to total research and development expenses, the internal costs without license amortization and write-off represented 44.6% of the total research and development costs for the nine months ended December 31, 2003, while internal costs were 50.2% of total research and development costs for the comparable 2002 period.

Gain on Sale of a Development Project to a Related Party

Depreciation and Amortization

Depreciation and amortization for the nine months ended December 31, 2003, increased by $0.9 million, or 15.3%, to $6.8 million from $5.9 million in the comparable 2002 period due to amortization expense of the Company’s license with Atari Interactive for the rights to the Atari name.

Interest Expense, net

Interest expense, net, decreased approximately $3.5 million to $7.2 million for the nine months ended December 31, 2003 from $10.7 million in the comparable 2002 period. The decrease is a result of the Company’s September 2003 recapitalization whereby all outstanding related party debt was converted to equity. Since the recapitalization, interest and financing fees have consisted solely of expenses incurred under the Company’s credit facility arrangement with GECC. Furthermore, interest expense has been further reduced by interest income received from advances to related parties of approximately $1.1 million. Offsetting this decrease in interest expense, the Company expensed the full $1.3 million remaining deferred financing fees outstanding as a result of the conversion of all outstanding related party debt to equity in the September 2003 quarter.

Other Expense

Other expense in the nine months ended December 31, 2003 included a $1.7 million write-down related to the Oddworld Transaction (see Note 10 of the Notes of these Consolidated Financial Statements for additional information related to this transaction). Other expense in comparable 2002 period included an initial write-down of the Oddworld investment of approximately $3.6 million, offset by $0.6 million of commission income recorded by the Company as compensation for negotiating a sale-lease back transaction for a related-party.

Provision for Income Taxes

During the nine months ended December 31, 2002, the Company recorded a provision for taxes of $2.2 million, the majority of which related to foreign tax liabilities of the Company’s foreign operations. During the nine months ended December 31, 2003, a nominal provision was recorded for miscellaneous state and foreign taxes paid based on the overall expected tax rate for the fiscal year.

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Liquidity and Capital Resources

Overview

As of December 31, 2003, management believes that the Company has sufficient capital resources to finance the Company’s operational requirements for the next twelve months, including the funding of the development, production, marketing and sale of new products, the purchases of equipment, and the acquisition of intellectual property rights for future products. On November 12, 2002, (last amended December 23, 2003), the Company obtained a 30-month $50.0 million Senior Credit Facility with GECC which was used to fund the Company’s working capital and general corporate needs and to provide funding to certain related parties which are wholly-owned by Infogrames SA. As part of the most recent amendment under the GECC Senior Credit Facility, the Company will no longer provide funding to related parties.

On September 4, 2003, the Company entered into a Recapitalization Agreement exchanging all of the Company’s related party debt, net of certain advances, with Infogrames SA and certain of its wholly-owned subsidiaries into shares of the Company’s common stock. Subsequently, on September 24, 2003, the Company issued new shares of its common stock in a secondary public offering generating net proceeds of $34.9 million, of which $3.9 million was used to repay the outstanding balance of the Senior Credit Facility with GECC. The remaining proceeds from the Offering are being used to pay costs of developing video game software and to meet general working capital needs. See the Company’s Registration Statement on Form S-2 for a discussion of “Risk Factors” that could materially impact expected cash flows.

Cash Flows

Cash was $9.0 million at December 31, 2003 compared to $0.8 million at March 31, 2003. As of December 31, 2003, the Company had working capital of $40.3 million compared to a working capital deficit of $91.6 million at March 31, 2003.

During the nine months ended December 31, 2003, the cash used in operating activities of $5.1 million and cash outflows from investing activities, mainly advances to related parties, were funded from $31.7 million of cash from financing activities. Since, September 30, 2003, however, approximately $23.9 million of the $34.9 million proceeds from the September 2003 equity offering have been used for operating activities, primarily to fund the seasonal growth in the Company’s accounts receivables during the holiday season. The Company also used proceeds from the equity offering to fund capital expenditures of $0.9 million during the December 2003 quarter. During the nine months ended December 31, 2003, the Company advanced Atari Interactive $14.4 million under the terms of the GECC Senior Credit Facility in order to support its operations. Atari Interactive develops games which the Company distributes in North America and, consequently, the Company is dependent, in part, on Atari Interactive’s development activities for growth in its publishing revenues. As part of the most recent amendment under the GECC Senior Credit Facility, the Company no longer provides funding to related parties.

The Company expects continued volatility in the use of cash due to seasonality of the business, receivable payment cycles and quarterly working capital needs to finance its publishing businesses and growth objectives.

The Company’s outstanding accounts receivable balance varies significantly on a quarterly basis due to the seasonality of its business and the timing of new product releases. There were no significant changes in the credit terms with customers during the nine month period.

The Company does not currently have any material commitments with respect to any capital expenditures.

The Company is also party to various litigation arising in the course of its business. Management believes that the ultimate resolution of these matters will not have a material adverse effect on the Company’s liquidity, financial condition or results of operations.

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Credit Facilities

GECC Senior Credit Facility

On November 12, 2002 (last amended December 23, 2003), the Company obtained a 30-month $50.0 million Senior Credit Facility with GECC to fund the Company’s working capital and general corporate needs, as well as to fund advances to Paradigm and Atari Interactive, each a related party. Loans under the Senior Credit Facility are based on a borrowing base comprised of the value of the Company’s accounts receivable and short term marketable securities. The Senior Credit Facility bears interest at prime plus 1.25% for daily borrowings or LIBOR plus 3% for borrowings with a maturity of 30 days or greater. A commitment fee of 0.5% on the average unused portion of the facility is payable monthly and the Company paid $0.6 million as an initial commitment fee at closing. The Senior Credit Facility contained certain financial covenants and named certain related entities, such as Atari Interactive and Paradigm, as guarantors. In addition, amounts outstanding under the Senior Credit Facility are secured by the Company’s assets. At December 31, 2003, $6.9 million of borrowings remained outstanding and $12.5 million of letters of credit were outstanding. As of December 31, 2003, accrued interest was $0.1 million and included in accrued liabilities. At December 31, 2003, the Company was in compliance with all financial covenants.

Infogrames SA credit facilities and debt with the Company

Credit Agreement

The Company maintained the Credit Agreement with Infogrames SA which provided for an aggregate commitment of $75.0 million which bore interest at LIBOR plus 2.5%. Effective December 31, 2002, the maturity date of the Credit Agreement was extended to April 1, 2004. This agreement required that the Company comply with certain financial covenants and, among other items, restricted capital expenditures. As of September 30, 2003, all outstanding borrowings were exchanged for 10,541,105 newly issued common shares under the terms of the Recapitalization Agreement. As of December 31, 2003, accrued interest and fees that remain outstanding were minimal and are included in current amounts due to related parties (See Note 1, Recapitalization, of the Notes of these Consolidated Financial Statements).

Medium-Term Loan

Long-Term Related Party Debt

0% Notes

In conjunction with the 1999 purchase of the Company by Infogrames SA, the Company issued to GAP the 0% Notes in exchange for 600,000 shares of Series A Preferred Stock and $20.0 million of subordinated notes of the Company. The 0% Notes mature in December 2004 and had a redemption value of $50.0 million at maturity. In lieu of payment at maturity, the 0% Notes were convertible at any time, at holder’s option, into shares of the Company’s common stock at $20.00 per share. On December 28, 2001, Infogrames SA assumed the 0% Notes from GAP in exchange for shares of Infogrames SA common stock. Infogrames SA did not change any of the terms of the 0% Notes (renamed the “Infogrames SA 0% subordinated convertible note”) as they relate to the Company. Interest on the Infogrames SA 0% subordinated convertible note was accreted at the rate of 7% per annum.

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Under the terms of the September 4, 2003 Recapitalization Agreement, the Infogrames SA 0% subordinated convertible note has been fully offset against the advances to related parties (Notes 1 and 5).

5% Notes

In conjunction with the 1999 purchase of the Company by Infogrames SA, the Company issued to CUSH, 5% CUSH Notes in exchange for $25.0 million in cash and $35.6 million in debt and accrued interest. The 5% CUSH Notes matured in December 2004 and have a principal amount of $60.6 million. In lieu of payment at maturity, the 5% CUSH Notes were convertible at any time, at holder’s option, into shares of the Company’s common stock at $9.25 per share.

In September 2003, the Company expensed $1.3 million of remaining deferred financing fees related to the Infogrames SA 0% subordinated convertible note and the 5% CUSH Notes as a result of the Recapitalization Agreement.

Contractual Obligations

As of December 31, 2003, royalty and license advance obligations and future minimum lease obligations under non-cancelable operating leases are summarized as follows (in thousands):


	Contractual Obligations Payments Due by Period
	Within 1 Year		1-3 Years		4-5 Years		After 5 Years		Total

Royalty and license advances	$	1,329	$	519	$	—	$	—	$	1,848
Operating lease obligations		5,900		11,900		1,800		1,200		20,800

Total	$	7,229	$	12,419	$	1,800	$	1,200	$	22,648

Recent Accounting Pronouncements

In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities”. In December 2003, the FASB issued FIN 46-R to address certain FIN 46 implementation issues. This interpretation requires that the assets, liabilities, and results of activities of a VIE be consolidated into the financial statements of the enterprise that has a controlling interest in the VIE. FIN 46-R also requires additional disclosures by primary beneficiaries and other significant variable interest holders. For entities acquired or created before February 1, 2003, this interpretation is effective no later than the end of the first interim or reporting period ending after March 15, 2004, except for those VIE’s that are considered to be special purpose entities, for which the effective date is no later than the end of the first interim or annual reporting period ending after December 15, 2003. For all entities that were acquired subsequent to January 31, 2003, this interpretation is effective as of the first interim or annual period ending after December 31, 2003. The adoption of the provisions of this interpretation did not have a material effect on the Company’s financial condition or results of operations.

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does not have any derivative instruments as defined in SFAS No. 149. Accordingly, this pronouncement is currently not applicable to the Company.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

The Company’s carrying value of cash, trade accounts receivable, accounts payable, accrued liabilities, royalties payable and its existing lines of credit are a reasonable approximation of their fair value.

Foreign Currency Exchange Rates

In recent years, the Company has restructured its foreign operations. As of December 31, 2003, foreign operations represented 0.0% and 1.0% of consolidated net revenues and total assets, respectively. The Company also recorded approximately $6.6 million in operating expenses attributed to foreign operations related primarily to a development studio located outside the United States. Currently, substantially all of the Company’s business is conducted in the United States where its revenues and expenses are transacted in U.S. dollars. As a result, the majority of the Company’s results of operations are not subject to foreign exchange rate fluctuations. The Company does not hedge against foreign exchange rate fluctuations due to the limited financial exposure it faces with respect to such risk. The Company purchases certain of its inventories from foreign developers. The Company also pays royalties primarily denominated in euros to Infogrames SA from the sale of Infogrames SA products in North America. The Company’s business in this regard is subject to certain risks, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. The Company’s future results could be materially and adversely impacted by changes in these or other factors.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures. As of December 31, 2003, with the participation of the Company’s management, the Chief Executive Officer and Chief Financial Officer of the Company evaluated the Company’s disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-15(e) and 15d-15(e)). In designing and evaluating the Company’s disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, except as set forth below, as of December 31, 2003, the Company’s disclosure controls and procedures were (1) designed to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to the Company’s Chief Executive Officer and Chief Financial Officer by others within those entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. In connection with the rules, we are continuing the process of reviewing and documenting our disclosure controls and procedures, including our internal controls and procedures for financial reporting, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with our business.

Based upon management’s evaluation, the Company’s procedures for ensuring that directors, officers and ten percent (10%) beneficial owners file transaction reports pursuant to Section 16 of the Securities Exchange Act of 1934, as amended (and the rules thereunder) are not yet effective. The Company is in the process of assessing and improving those procedures and expects that all appropriate procedures shall be implemented prior to the date on which the Company will file its Form 10-K for the fiscal year ending March 31, 2004.

Changes in Internal Controls. No change in the Company’s internal control over financial reporting (as defined in the Exchange Act Rules 13a-15(f) and 15d-15(f)) occurred during the fiscal quarter ended December 31, 2003, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Litigation

During the nine months ended December 31, 2003, no significant claims were asserted against or by the Company that in management’s opinion the likely resolution of which would have a material adverse affect on the Company’s liquidity, financial condition or results of operations, although the Company is involved in various claims and legal actions arising in the ordinary course of business. The following litigation matters are still pending or were terminated during the period. The Company continues to believe, with respective to pending matters, that the underlying complaints are without merit and intends to defend itself vigorously against these actions.

The Company’s management believes that the ultimate resolution of any of the complaints summarized below and/or any other claims which are not stated herein will not have a material adverse effect on the Company’s liquidity, financial condition or results of operations.

KBK

On September 16, 2002, KBK, a distributor of electronic games via the Internet and local area networks, filed a lawsuit against Gamesonline, a subsidiary of Interplay, and the Company in Superior Court of California, Orange County. KBK alleges that on or about December 15, 2001, KBK entered into a contract with Gamesonline to obtain the right to localize (i.e., right to translate games into the local language of the country where the games are distributed) and to electronically distribute in Korea, Neverwinter Nights and certain other games which were previously released. The complaint further alleges that Gamesonline and the Company conspired to prevent KBK from entering the market with Neverwinter Nights or any previously released games of Gamesonline. The complaint alleges the following causes of action against the Company: misappropriation of trade secrets under the California Uniform Trade Secrets Act; common law misappropriation; intentional interference with contract; negligent interference with contract; intentional interference with prospective economic advantage; negligent interference with prospective economic advantage; and violation of Business & Professions Code Section 17200 et seq. The complaint seeks $98.8 million for each of these causes of action.

Interplay

On September 19, 2003, Interplay commenced the Action in New York State Supreme Court, New York County in which it named Atari Interactive and the Company as defendants, seeking, among other things, a judgment declaring that a computer game license agreement between Interplay and Atari Interactive continues to be in full force and effect.

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Item 6. Exhibits and Reports on Form 8-K


(a) Exhibits

3.1		Amended and Restated By-Laws of Atari, Inc. (conformed)

3.2		Amendment No. 1 to the Amended and Restated By-Laws of Atari, Inc., effective as of November 21, 2003.

10.1		Sixth Amendment to Credit Agreement, dated as of December 23, 2003, among the Company, as Borrower, the other Credit Parties signatory thereto, the Lenders signatory thereto from time to time, and General Electric Capital Corporation, as Administrative Agent, Agent and Lender.

10.2		First Amendment to Intercreditor and Subordination Agreement, dated as of December 23, 2003, among Infogrames Entertainment S.A, California U.S. Holdings, Inc., Atari Interactive, Inc., General Electric Capital Corporation and the Credit Parties signatory thereto.

31.1		Certification by the Company’s Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification by the Company’s Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification by the Company’s Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification by the Company’s Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

On November 3, 2003, the Company furnished a Current Report on Form 8-K pursuant to Item 12 (Results of Operations and Financial Condition), containing a copy of the Company’s earnings release for the quarter ended September 30, 2003 (including financial information).

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		ATARI, INC.

		By:		/s/ DAVID J. FREMED

				David J. Fremed
				Senior Vice President of Finance and
				Chief Financial Officer

Date: February 13, 2004

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	•		The Company’s publishing business experienced a 3.0% decline in publishing net revenues to $174.4 million from $179.8 million in the December 2002 quarter because of lower replenishment orders over the holiday season. Top sellers in the current quarter include titles from the Dragon Ball Z franchise (DBZ: Budokai 2 (Playstation2), DBZ: Budokai Greatest Hits (Playstation2) and DBZ: Taiketsu (Gameboy Advance)) as well as new releases Yu Yu Hakusho: Spirit Detective (Gameboy Advance), Backyard Basketball (Playstation2), Terminator 3: Rise of the Machines (Playstation 2 and Xbox), Mission Impossible — Operation Surma (Playstation 2 and Xbox), and Beyblades: Ultimate Blader Jam (GBA).

	•		Publishing net revenues in the 2003 period include nearly $10.0 million in royalty income earned from the sale of US product in Europe, while the December 2002 period included $7.0 million in similar royalty income. Approximately $1.7 million of the $3.0 million increase is a benefit of the weakening dollar on revenues earned in euros. The remainder of the increase is from strong international sales of December 2003 quarter releases, mainly of

			Mission Impossible-Operation Surma (Playstation2 and Xbox) and Terminator 3: Rise of the Machines (Playstation2 and Xbox), than of December 2002 quarter releases.

	•		Additionally, the Company recognized $3.5 million of previously deferred revenue from sublicensing income as a result of a termination of its sublicensing arrangement with Microsoft. See Note 10 of the Notes of these Consolidated Financial Statements for additional information related to this transaction.

	•		Distribution net revenues decreased from $30.8 million to $16.2 million due primarily to the Company’s decision to reduce its third party distribution operations in the specific instances where margins are considered insufficient.

	•		A 4.5% decline in publishing net revenues from $371.7 million in the December 2002 period to $355.0 million in the December 2003 period is the combined result of reduced replenishment orders in the current quarter and a light schedule of new product releases in the prior (September 2003) quarter, partially offset by stronger international royalty income earned on Infogrames SA’s international sales of the Company’s titles in the current year.

	•		Publishing revenues include international royalty income earned on Infogrames SA’s international sales of the Company’s titles which is up by $10.1 million from $17.2 million in 2002 to $27.3 million in 2003. The increase includes a favorable exchange rate impact in the current fiscal year of approximately $4.2 million from the weakening US dollar against the euro and strong fiscal 2004 international sales of Enter the Matrix (Playstation2, Xbox, PC and GameCube).

	•		Additionally, the Company recognized $3.5 million of previously deferred revenue from sublicensing income of as a result of a termination of its sublicensing arrangement with Microsoft. See Note 10 of the Notes of these Consolidated Financial Statements for additional information related to this transaction.

	•		Total distribution net revenues decreased 39.0% from $77.9 million to $47.5 million from continued general industry softness in productivity software and the Company’s decision to reduce its third party distribution operations in the specific instances where margins are considered insufficient.