UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended September 30, 2004

OR

ATARI, INC.

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

(212) 726-6500
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
Yes [X] No [  ]

     As of November 5, 2004, there were 121,279,275 of the registrant’s Common Stock outstanding.

ATARI, INC. AND SUBSIDIARIES
SEPTEMBER 30, 2004 QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

ATARI, INC. AND SUBSIDIARIES

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

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ATARI, INC. AND SUBSIDIARIES

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

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ATARI, INC. AND SUBSIDIARIES

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

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ATARI, INC. AND SUBSIDIARIES

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

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ATARI, INC. AND SUBSIDIARIES

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER MATTERS

     Nature of Business

          We are a leading global publisher and developer of video game software for both gaming enthusiasts and the mass-market audience, as well as a leading distributor of video game software in North America. We publish and distribute games for all platforms, including Sony PlayStation and PlayStation 2; Nintendo Game Boy, Game Boy Advance and GameCube; Microsoft Xbox; and personal computers, referred to as PCs. We also publish and sub-license games for wireless devices, the internet, and other evolving platforms. Our diverse portfolio of products extends across every major video game genre, including: action, adventure, strategy, children, family, driving and sports games.

          Through our relationship with our majority stockholder, Infogrames Entertainment S.A., a French corporation (“IESA”), listed on Euronext, our products are distributed exclusively by IESA throughout Europe, Asia and certain other regions. Similarly, we exclusively distribute IESA’s products in the United States, Canada and their territories and possessions. At September 30, 2004, IESA owns approximately 59% of us directly and through its wholly-owned subsidiary California U.S. Holdings, Inc. (“CUSH”) and its majority-owned subsidiary Atari Interactive, Inc. (“Atari Interactive”).

          During September 2003, we entered into a series of transactions to restructure our 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, we secured long-term rights to the Atari name (“Atari License”). (See Recapitalization, Atari License, and Offering below.)

     Recapitalization

          In September 2003, we, IESA, and CUSH entered into an agreement (“Recapitalization Agreement”) resulting in the exchange of all of our net related party debt with IESA and certain of its wholly-owned subsidiaries totaling $165.9 million into 39,029,877 shares of our common stock immediately prior to the Offering. Accordingly, at March 31, 2004 and September 30, 2004, 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. However, we have $8.6 million and $7.3 million in related party notes receivable outstanding at March 31, 2004 and September 30, 2004, respectively, which arose after the Recapitalization and are related to certain other transactions. Such notes are permitted by the GECC senior credit facility (see Note 7). As of September 30, 2004, Atari Interactive and Paradigm Entertainment, Inc. (“Paradigm”) have amounts past due related to these notes of approximately $5.6 million. We renegotiated the payments of and security for these related party notes receivable as of November 3, 2004 (see Note 5).

          In connection with the Recapitalization Agreement, we issued stock to IESA at the same price as in the Offering (see Offering below), which was 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 the additional stock issued was reported as a dividend to IESA for $39.4 million during the September 2003 quarter, which had no impact on total stockholders’ equity.

     Atari License

          In connection with the Recapitalization Agreement, Atari Interactive extended the term of the license under which we use the Atari name to ten years expiring on December 31, 2013. We issued 2,000,000 shares of our common stock to Atari Interactive for the extended license and will pay a royalty equal to 1% of our net revenues during years six through ten of the extended license. We recorded a deferred charge of $8.5 million, representing the fair market value of the shares issued, 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 us over the ten-year license period. At September 30, 2004, $3.4 million of this deferred charge is included in Prepaid Expenses and Other Current Assets with the remaining $1.7 million, net of $3.4 million of amortization, included in Other Assets.

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     Offering

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

          Additionally, on September 24, 2003, IESA sold 17,179,412 shares of our common stock as part of the Offering. We did not receive any proceeds from the sale by IESA of our common stock. Finally, on October 21, 2003, the underwriters exercised their over-allotment option, purchasing 3,855,400 shares from IESA at a purchase price of $4.25 per share. We did not receive any of the proceeds from the exercise of the over-allotment option.

     Basis of Presentation

          Our accompanying interim consolidated financial statements 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 our Annual Report on Form 10-K for the year ended March 31, 2004.

     Principles of Consolidation

          The consolidated financial statements include our accounts and our 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.

          We are not contractually obligated to accept returns except for defective product. However, we may permit our customers to return or exchange product and we provide allowances for estimated returns, price concessions, or other allowances on a negotiated basis. We estimate such returns and allowances based upon management’s 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.

     Goodwill and Other Intangible Assets

          Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”, eliminates goodwill amortization over its estimated useful life. 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 our intent to do so. Intangible assets with finite lives are amortized over their useful lives. As of March 31, 2004, we performed our annual fair-value based assessment which did not result in any impairment of goodwill or intangibles. As of September 30, 2004, we do not believe that there are any indications of impairment of goodwill or intangibles. However, future changes in the facts and circumstances relating to our goodwill and other intangible assets could result in an impairment of intangible assets in subsequent periods.

          Other intangible assets approximate $1.4 million and $1.1 million, net of accumulated amortization of $1.3 million and $1.6 million at March 31, 2004 and September 30, 2004, respectively.

     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 materially differ from those estimates.

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     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, related party notes receivable, and amounts due to and from related parties are reflected in the consolidated financial statements at fair value due to the short-term maturity and the denomination in US dollars of these instruments.

     Long-Lived Assets

          We review 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, whether internally or externally developed, 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.

          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, we follow the policy of expensing milestone payments as incurred, treating such costs as research and development expenses.

     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 an impairment in value, if any, as research and development expense.

     Income Taxes

          We account 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. We record an allowance to reduce tax assets to a realizable amount. We monitor our tax liability on a quarterly basis and record the estimated tax obligation based on our current year-to-date taxable income and expectations of the full year results.

     Loss Attributable to Common Stockholders Per Share

          Basic loss attributable to common stockholders per share is computed by dividing loss attributable to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted loss attributable to common stockholders per share reflects the potential dilution that could occur from shares of common stock issuable through stock-based compensation plans including stock options, restricted stock awards, warrants using the treasury stock method and other convertible securities. All shares issuable through stock-based compensation plans were antidilutive in the periods presented because we incurred losses during all such periods. The following is a reconciliation of basic and diluted loss attributable to common stockholders per share (in thousands, except per share data):

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          The number of antidilutive shares that were excluded from the diluted earnings per share calculation were 14,809,000 and 15,960,000, respectively, for the three months and six months ended September 30, 2003 and 5,524,000 for both the three months and six months ended September 30, 2004. These shares were antidilutive due to the loss attributable to common stockholders for the periods presented.

     Stock-Based Compensation

          We account for employee stock option plans under the intrinsic value method prescribed 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. We have also adopted the disclosure provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123, “Accounting for Stock-Based Compensation”, as amended by FASB Statement No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an Amendment to FASB Statement No. 123”.

          At September 30, 2004, we had three stock option plans. No compensation cost is reflected in net loss, as all options granted under those plans 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 loss attributable to common stockholders and loss attributable to common stockholders per share if we 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):

          The fair market value of options granted under stock option plans during the three months and six months ended September 30, 2003 and 2004 was determined using the Black-Scholes option pricing model utilizing the following assumptions:

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NOTE 2 — RECEIVABLES, NET

          Receivables consist of the following (in thousands):

NOTE 3 — INVENTORIES, NET

          Inventories consist of the following (in thousands):

NOTE 4 — ACCRUED LIABILITIES

          Accrued liabilities consist of the following (in thousands):

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NOTE 5 — RELATED PARTY TRANSACTIONS

Related Party Notes Receivable

          On March 31, 2004, Atari Interactive and Paradigm, respectively, issued to us the following related party notes receivable which bore interest, prior to default, at prime plus 1.25%.

          As of September 30, 2004, Atari Interactive and Paradigm have amounts past due related to these notes of approximately $5.6 million. We renegotiated the payments of and security for these related party notes receivable as of November 3, 2004. For a description of renegotiated terms see the IESA Liquidity subsection in this footnote.

          Related party notes receivable consist of the following amounts (in thousands):

(1) This note is payable at the earlier of the release of certain development projects to the public or December 31, 2004. One project was released to the public on September 14, 2004. On September 30, 2004, we offset royalties due to Atari Interactive of approximately $1.3 million against the portion of the principal that was past due.

(2) The Atari Interactive note and the Paradigm note are payable on September 30, 2004.

(3) As security for the related party notes receivable, Atari Interactive has agreed to not transfer, assign, sell, pledge or otherwise dispose of or encumber 2,000,000 shares of our common stock given to Atari Interactive as part of the Atari License. (See Note 1, Atari License.) Additionally, such notes have been provided to GECC as additional security. In connection with the obligation, assignment, and security agreement dated November 3, 2004, future royalties due to Atari Interactive, IESA, or its other subsidiaries will be applied to amounts due on these notes.

          For the three months and six months ended September 30, 2004, $0.1 million and $0.2 million, respectively, of interest income has been earned on the Atari Interactive notes and a nominal amount remains outstanding at September 30, 2004. A nominal amount of interest income was earned on the Paradigm note during the three months and six months ended September 30, 2004.

Royalty Agreement

          Royalties transactions are as follows (in thousands):

(1) We have a distribution agreement with IESA which provides for IESA’s distribution of our products across Europe, Asia, and certain other regions pursuant to which IESA pays us 30.0% of the gross profit on such products or 130.0% of the royalty rate due to the developer, whichever is greater. We recognize this amount as royalty income which is included in net revenues.

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(2) The distribution agreement with IESA also provides for our distribution of IESA’s (or any of its subsidiaries’) products in the United States, Canada and their territories and possessions, pursuant to which we pay IESA either 30.0% of the gross profit on such products or 130.0% of the royalty rate due to the developer, whichever is greater. We recognize this amount as royalty expense which is included in cost of goods sold.

          As of March 31, 2004 and September 30, 2004, the following amounts are outstanding with regard to related party royalty transactions and are included in due from related parties (in thousands):

          As of September 30, 2004, $15.7 million of these royalties receivable are past due. We renegotiated the payments of and security for this royalty receivable as of November 3, 2004. For a description of renegotiated terms, see the IESA Liquidity subsection in this footnote.

Options Issued to Paradigm on behalf of IESA

          On July 30, 2004, 27,500 options to purchase our common stock were issued to two officers of Paradigm on behalf of IESA. The options were valued at a nominal amount using the Black-Scholes model. As of September 30, 2004, Paradigm reimbursed us for the expense incurred related to the issuance of these options.

IESA Liquidity

          IESA has incurred significant continuing losses from operations and is highly leveraged. IESA owns, directly and indirectly, approximately 59% of our stock, distributes our products in Europe, Asia, and certain other regions, and pays us royalties in this respect. IESA also develops products which we distribute in the U.S., Canada, and their territories and possessions, and for which we pay royalties to IESA. As at September 30, 2004, royalty payments due and payable to us by IESA under our existing distribution agreement for the period then ended amounted to approximately $15.7 million. In addition, as at that same date, amounts due and payable to us by Atari Interactive and Paradigm, respectively, amounted to approximately $4.8 million and to $0.8 million, in respect of promissory notes.

          On November 3, 2004, we entered into an agreement with IESA and several of its subsidiaries under which, in lieu of receiving payment on the above past due amounts, we transferred the amounts due to us from IESA and Paradigm to Atari Interactive in exchange for a secured promissory note (the “Secured Note”) from Atari Interactive that also includes in the initial principal amount the sums currently due to us from Atari Interactive and a $1.6 million note payment that would have been due from Atari Interactive on December 31, 2004, and interest on those amounts of approximately $0.1 million. Specifically, the Secured Note has a principal amount of approximately $23.1 million, will mature on March 31, 2005, bears annual interest at the prime rate plus 3.25%, and is secured by 2,000,000 shares of our common stock owned and pledged by Atari Interactive and by the rights, as owner, to the “Atari” trademark and the Fuji logo in North America (collectively, the “Collateral”). The “Atari” trademark and “Fuji” logo currently are owned by Atari Interactive and licensed to us through 2013 under the terms of the Trademark License Agreement, dated September 4, 2003.

          If Atari Interactive fails to pay all outstanding principal and interest it owes to us in respect of the Secured Note when due on March 31, 2005, or if Atari Interactive otherwise defaults on its obligations to us thereunder, we will have the contractual right to foreclose on the Collateral. We have the right to apply royalties we will owe to Atari Interactive or to IESA or other if its subsidiaries in reduction of the Secured Note, instead of paying the royalties. Based on our projected royalty obligations to Atari Interactive, IESA and its other subsidiaries, we anticipate that by March 31, 2005, we will have applied most if not all of those amounts against amounts owed to us under the Secured Note.

          In October 2004, IESA entered into an agreement with certain of its bank lenders under which it restructured the repayment terms of its debt obligations to those banks, extending the maturity dates thereof. IESA also entered into arrangements with certain of its banks in order to finance its operations through the upcoming holiday season.

          Although we are not a party to, or a guarantor of, and have no obligations or liability in respect of IESA’s indebtedness to its bank lenders or any of its other creditors, IESA distributes our products in Europe and elsewhere, other than in North America, and both IESA and Atari Interactive are material sources of products which we market in the United States and Canada.

          If IESA is unable to address its liquidity problems and fund its working capital needs through a debt refinancing or by raising equity capital, selling assets or completing a similar transaction, IESA would likely be unable to fund the video game development operations of Atari Interactive, and our results of operations could be materially impaired because our revenue from the distribution of Atari Interactive and IESA products could decrease materially. Such a reduction of our revenues, among other things, could result in a breach of one or more of the covenants contained in our senior credit facility with GECC. If the above contingencies occurred, we probably would be forced to take actions that, could include, but would not necessarily be limited to, a significant reduction in our expenditures for internal and external new product development and the implementation of a comprehensive cost reduction program to reduce our overhead expenses. These actions, should they become necessary, could result in a significant reduction in the size of our operations and could have a material adverse effect on our revenue and cash flows. At present there can be no assurance regarding any of the foregoing contingencies and management will continue to monitor these developments closely.

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NOTE 6 — COMMITMENTS AND CONTINGENCIES

Litigation

          During the six months ended September 30, 2004, no significant claims were asserted against or by us that, in management’s opinion, the likely resolution of which would have a material adverse affect on our liquidity, financial condition or results of operations, although we are involved in various claims and legal actions arising in the ordinary course of business. The following is a summary of pending litigation matters. With respect to matters in which we are the defendant, we believe that the underlying complaints are without merit and intend to defend ourselves vigorously.

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

Knight Bridging Korea v. Infogrames, Inc. et al.

          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 us in Superior Court of California, Orange County (the “Court”). KBK alleges that on or about December 15, 2001, KBK entered into a contract with Gamesonline to obtain the right to localize and distribute electronically in Korea, Neverwinter Nights and certain back list games. The complaint further alleges that Gamesonline and we conspired to prevent KBK from entering the market with Neverwinter Nights or any back title of Gamesonline. The complaint alleges the following causes of action against us: 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 us, adding Atari Interactive (f/k/a Infogrames Interactive, Inc.) as a named defendant, and alleging that we managed and directed Atari Interactive to engage in the foregoing alleged acts. We 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 defendants Does 2, 3 and 4 as “Infogrames Asia Pacific”, “Infogrames Korea” and “Interplay, Inc.”, respectively. On October 29, 2003, Interplay filed a cross-complaint against us, Atari Interactive, Infogrames Korea and Roes 101 through 200. We and Atari Interactive filed an answer on December 3, 2003. On March 25, 2004, KBK filed a Second Amended Complaint for Damages adding new causes of action for fraud against Gamesonline and Interplay; seeking rescission of the Electronic Distribution Agreement between KBK and Gamesonline; for “breach of third party beneficiary rights” against Atari Interactive; for unlawful restraint of trade against all defendants; for RICO Act violations against all defendants; and for civil conspiracy against all defendants; and adds allegations of alter ego status between Gamesonline and Interplay and as between us, Atari Interactive, and Atari Korea. Discovery is ongoing.

          On March 10, 2004, the Court entered a stipulation among the parties referring the matter to a private judge. The private judge retired Superior Court Judge Harvey Schneider, will be presiding over all aspects of the case, including the non-jury trial.

          We and Atari Interactive prevailed on a Motion for Leave to File a Cross-Complaint against Interplay and Gamesonline. We and Atari Interactive also prevailed on a Motion for Summary Adjudication on the RICO Act claim.

          On July 1, 2004, KBK filed a Third Amended Complaint whereby certain previous allegations were either omitted or clarified as a result of the Court’s rulings at the June 17, 2004 hearings.

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          KBK has purported to serve in Korea an entity it called “Atari Korea” with a Summons and Complaint in this case. Atari Korea Ltd. filed a Motion to Quash Service based on failure to comply with the terms of the Hague Convention and/or lack of personal jurisdiction over that entity. This motion was granted.

          On or about October 1, 2004, KBK’s litigation counsel resigned. On October 8, 2004, we and Atari Interactive filed an ex parte application to strike KBK’s pleadings or, in the alternative, for an order shortening the time to hear such application as noticed motions. The ex parte application was heard and denied on October 11, 2004 but the Court did grant the application for a shortened period of time to hear such application as noticed motions. On October 19, 2004, the Court granted our Motion to Strike KBK’s Pleadings due to the fact that KBK has no counsel to represent it in the litigation and did not file any opposition to the motion. The Court dismissed KBK’s complaint without prejudice. The cross-claims have not been dismissed by the other parties to the litigation. We and Atari Interactive are in discussions with the other parties with respect to same.

Atari, Inc., Atari Interactive, Inc., and Hasbro, Inc. v. Games, Inc., Roger W. Ach, II , and Chicago West Pullman LLC

          On May 17, 2004, we and Atari Interactive together with Hasbro, Inc. (“Hasbro”) filed a complaint against Games, Inc. (“Games”), its CEO, Roger W. Ach, II (“Ach”), and Chicago West Pullman LLC (“Chicago West Pullman”) in the United States District Court for the Southern District of New York and sought a temporary restraining order and preliminary injunction to stop Games’ and Ach’s use of certain trademarks and copyrights owned by Atari Interactive and Hasbro. We, Atari Interactive, and Hasbro (“the plaintiffs”) allege that an interim license that we granted to Games for the development and publication of certain games in a specified online format expired by its terms when Games failed to pay us certain fees by April 30, 2004, pursuant to an Asset Purchase, License and Assignment Agreement between us and Games dated December 31, 2003, as amended (the “Agreement”). The plaintiffs allege that Games’ failure to pay voided an expected transfer of the “games.com” domain name and certain web site assets from us to Games and constituted a breach of contract and that Chicago West Pullman’s failure to pay constituted a breach of guarantee. The plaintiffs further allege that upon the expiration of the interim license, all intellectual property rights granted under that license reverted back to us, but that Games nevertheless continued to use the plaintiffs’ intellectual property. On May 18, 2004, the Court granted a temporary restraining order against Games and Ach and scheduled a preliminary injunction hearing for May 28, 2004, which was postponed until June 11, 2004. Prior to that hearing, Games’ agreed to the preliminary injunction and the Court signed an order granting the preliminary injunction pending the outcome of the case.

          On June 16, 2004, Games served its Answer and Counterclaim to the complaint. In its counterclaim, Games alleges that the plaintiffs breached the Agreement and a Settlement Agreement dated March 31, 2004 by, inter alia, licensing other web sites to use on-line play of certain Atari and Hasbro games that Games claimed were part of its exclusive license under the Agreement.

          On June 23, 2004, the Court ordered that the parties attend a case management conference scheduled for June 29, 2004. At the June 29, 2004, case management conference, Games’ counsel raised issues relating to the plaintiffs’ failure to respond to its discovery requests. The Court directed that the plaintiffs submit a letter brief setting forth its generic objections to Games’ discovery requests. The Court ordered that the plaintiffs’ letter brief be submitted by July 6, 2004 and that Games submit its reply by July 13, 2004. The Court also scheduled a teleconference for July 14, 2004. On July 6, 2004, the plaintiffs submitted their letter brief to the Court and also served Games with its Rule 26(a)(1) initial disclosures and answer to the counterclaim.

          Games’ counsel failed to appear for the July 14, 2004, teleconference and it was adjourned to July 15, 2004. At that teleconference, the Court granted the majority of the plaintiffs’ motion to quash Games’ discovery requests. As a result of the Court’s ruling, the plaintiffs do not have to produce any documents that were created on or before March 31, 2004, any documents relating to derivative games, or any documents relating to any license agreements with third parties concerning derivative games, downloads, or streaming.

          On July 16, 2004, it came to the plaintiffs’ attention that, in flagrant violation of the preliminary injunction, Games had issued a press release on July 13, 2004, that erroneously stated that Games owned the “games.com” web site and that it had an exclusive license to certain Atari and Hasbro games. The plaintiffs immediately brought the erroneous press release to the attention of Games’ counsel. On that same day, Games replaced the erroneous press release with a corrected press release, but refused to issue a corrective press release explaining that it in fact did not own either the web site or have any license to Atari and Hasbro games. On July 19, 2004, the plaintiffs brought this to the attention of the Court, who ordered that a corrective press release be issued, but approved language submitted by Games’ counsel.

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          On September 3, 2004, in a teleconference with the Court, Games requested from the Court that the plaintiffs be ordered to produce agreements with third parties from the first quarter of 2004 concerning online play of certain Atari and Hasbro games. During that same teleconference, the plaintiffs sought permission to move to dismiss the counterclaims against Atari Interactive and Hasbro. On September 8, 2004, the Court broadened the scope of discovery to include documents regarding contracts and negotiations between us and Hasbro and third parties between January 1, 2004 and March 31, 2004 regarding online play of the original classic versions of the games. The Court also set a schedule for the plaintiffs’ motion to dismiss the Counterclaims, which has been fully submitted and is under judicial deliberation.

          On October 4, 2004, it came to the plaintiffs’ attention that, once again, Games was in flagrant violation of the preliminary injunction because it represented in its Form 10-KSB filing dated October 1, 2004, that Games owned the domain name “games.com” and that it had an exclusive license to certain Hasbro and Atari games. The plaintiffs immediately brought this to the attention of Games’ counsel, who represented that certain, but not all, statements would be amended. But Games did not amend its Form 10-KSB. Accordingly, the plaintiffs sought permission to move for contempt for violation of the preliminary injunction.

          On October 14, 2004, in a teleconference with the Court, the Court granted the plaintiffs’ request to move for contempt, and ordered that the parties brief that motion on the same schedule as the briefing schedule for motions for summary judgment. The Court also reset the schedule for this case. All discovery is to be completed by November 12, 2004, opening briefs on summary judgment are due on November 29, 2004, answering papers are due on December 13, 2004, and reply papers are due on December 20, 2004. Oral argument for summary judgment is scheduled for January 10, 2004. The Court did not set a date for trial, which had previously been scheduled for November 29, 2004. The parties have completed document production and are in the process of taking depositions of witnesses.

Atari, Inc., Electronic Arts, Inc. and Vivendi Universal Games, Inc. v. 321 Studios, LLC

          On June 14, 2004, we, Electronic Arts, Inc. (“Electronic Arts”) and Vivendi Universal Games, Inc. (“Vivendi”) filed a lawsuit against 321 Studios, LLC (“321 Studios”), in U.S. District Court for the Southern District of New York. We, Electronic Arts, and Vivendi alleged that 321 Studios violated the Digital Millennium Copyright Act because its Games X Copy software circumvents copy protection technology embedded on video game CDs and DVDs. We, Electronic Arts, and Vivendi filed a Preliminary Injunction Motion on July 1, 2004. 321 Studios has not answered the Complaint nor has it responded to the Preliminary Injunction Motion. The litigation is being coordinated by the ESA (the Entertainment Software Association) and the costs associated with the litigation are being paid by the ESA. The parties have been negotiating settlement terms and are close to finalizing same.

American Video Graphics, L.P., v. Electronic Arts, Inc. et al.

     On August 23, 2004, American Video Graphics, L.P. filed a lawsuit against us, Electronic Arts, Inc., Take-Two Interactive Software, Inc., Ubi Soft, Activision Inc., THQ, Inc., Vivendi Universal Games, Inc., Sega of America, Inc., Square Enix, Inc., Tecmo, Inc., Lucasarts, a division of Lucas Films Entertainment Co., Ltd., and Namco Hometek, Inc. in the United States District Court for the Eastern District of Texas, Tyler Division (Case No. 6:04 CV-398-LED). We were served with the Summons and Complaint on September 7, 2004. The complaint alleges infringement of US Patent No. 4,734,690 (method and apparatus for spherical panning) and seeks unspecified damages. We were served with a First Amended Complaint on or about October 7, 2004, which amended the original complaint to properly name certain of the other defendants in the suit. On or about November 8, 2004, we filed our answer to such complaint.

NOTE 7 — DEBT

Credit Facilities

          GECC Senior Credit Facility

          On November 12, 2002 (last amended November 3, 2004), we obtained a 30-month $50.0 million senior credit facility with GECC to fund our working capital and general corporate needs, as well as to fund advances to Atari Interactive and Paradigm, each a related party. Loans under the senior credit facility are based on a borrowing base comprised of the value of our 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 we paid

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$0.6 million as an initial commitment fee at closing. The senior credit facility contains certain financial covenants and originally named certain related entities, such as Atari Interactive and Paradigm, as guarantors. In addition, amounts outstanding under the senior credit facility are secured by our assets. As of September 30, 2004, no borrowings are outstanding under the senior credit facility; however, $6.1 million of letters of credit were outstanding. As of September 30, 2004, accrued interest of approximately $0.3 million is included in accrued liabilities and we were in compliance with all financial covenants (see Note 5).

          Under an amendment to the senior credit facility, dated December 23, 2003, Atari Interactive and Paradigm have been removed as guarantors. Furthermore, under the amendment, we are no longer permitted to fund advances to Atari Interactive and Paradigm unless otherwise approved by GECC. All outstanding related party notes receivable have been approved, as well as the renegotiated debt arrangement with Atari Interactive and Paradigm.

NOTE 8 — OPERATIONS BY REPORTABLE SEGMENTS

          We have three reportable segments: publishing, distribution and corporate. Publishing is comprised of two studios located in Santa Monica, California, and Beverly, Massachusetts. Closed in March 2004, the Minnesota studio was included in September 30, 2003 figures. Distribution consists of 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 and distribution segments. This amount consists of depreciation on computers and office furniture at the publishing unit. Historically, we do 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. We evaluate performance based on operating results of these segments.

          Our 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 six months ended September 30, 2003 and 2004 (in thousands):

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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. We caution 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 we believe 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 us, are inherently subject to significant business, economic and competitive uncertainties and contingencies and known and unknown risks. As a result of such risks, our actual results could differ materially from those expressed in any forward-looking statements made by, or on behalf of, us. 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 us; and pricing of and demand for distributed products. Please see the “Risk Factors” in our Annual Report on Form 10-K for the year ended March 31, 2004 on file with the Securities and Exchange Commission for a description of some, but not all, risks, uncertainties and contingencies. Except as otherwise required by the applicable securities laws, we disclaim any intention or obligation publicly to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

Business and Operating Segments

          We are 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 our major activities. Development activities include development of games by both internal and external development studios. Internal studios are studios owned by us for the sole purpose of game development and external development studios are independent studios with which we or IESA and its subsidiaries have contracts for the development of specific titles. Our 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.

          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 and Toys ‘R’ Us; and specialty stores such as Electronics Boutique and GameStop. Additionally, our games are made available through various Internet and online networks. Our sales to key customers Wal-Mart, Target, Best Buy and GameStop accounted for approximately 24.4%, 10.5%, 8.5% and 7.8%, respectively, of net revenues for the six months ended September 30, 2004.

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 costs 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, we are determined to achieve balances between internal and external development, and licensed and proprietary products.

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Critical accounting policies

          Our discussion and analysis of financial condition and results of operations are based upon our 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 us 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, we evaluate our estimates, including those related to accounts and notes receivable, inventories, intangible assets, investments, income taxes and contingencies. We base our 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.

          We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our 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. We are not contractually obligated to accept returns; however, based on facts and circumstances at the time a customer may request approval for a return, we may permit the return or exchange of products sold to certain customers. In addition, we 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, retailer inventory levels, budgeted customer allowances, the nature of the title 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.

          We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make payments when due or within a reasonable period of time thereafter. If the financial condition of our 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 September 30, 2003 and 2004, we recorded allowances for bad debts, returns, price protection and other customer promotional programs of approximately $19.4 million and $17.1 million, respectively. For the six months ended September 30, 2003 and 2004, we recorded allowances for bad debts, returns, price protection and other customer promotional programs of approximately $50.9 million and $41.1 million, respectively. As of March 31, 2004 and September 30, 2004, the aggregate reserves against accounts receivables for bad debts, returns, price protection and other customer promotional programs were approximately $36.3 million and $25.1 million, respectively.

Inventories

          We write down our 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 September 30, 2003 and 2004, we recorded obsolescence expense of approximately $0.2 million and $0.6 million, respectively. For the six months ended September 30, 2003 and 2004, we recorded obsolescence expense of approximately $0.6 million and $1.1 million, respectively. As of March 31, 2004 and September 30, 2004, the aggregate reserve against inventories was approximately $2.1 million and $2.0 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, we follow 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 us. Subsequent payments are due as the specific contractual milestones are met by the developer and approved by us. 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.

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Income taxes

          As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our 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 our 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 September 30, 2004, we have combined net operating loss carryforwards of approximately $479.2 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 2024. We experienced an ownership change in 1999 as a result of the acquisition by IESA. 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 $186.8 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 our 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.

Related party transactions

          We are involved in numerous related party transactions with IESA 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 distribution agreements. See the Notes to the Consolidated Financial Statements contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission for the year ended March 31, 2004 for details, as well as the notes to the financial statements included in this quarterly report.

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Results of operations

          Three months ended September 30, 2004 versus the three months ended September 30, 2003

Consolidated Statement of Operations (dollars in thousands):

Net Revenues

Net Revenues by Segment (in thousands):

     Net revenues for the three months ended September 30, 2004 increased approximately $10.8 million or 17.8% from $60.6 million to $71.4 million.

•

Our publishing net revenues for the three months ended September 30, 2004 were driven by strong sales from new products and reorders of DRIV3R. New releases in the current quarter included Test Drive: Eve of Destruction (PlayStation 2 and Xbox), Dragonball Z: Buu’s Fury (Game Boy Advance), Terminator 3: The Redemption (PlayStation 2, Xbox, and GameCube), Demon Stone (PlayStation 2), and YuYu Hakusho: Dark Tournament (PlayStation 2), which produced net U.S. revenues aggregating approximately $17.2 million. The comparable period in the prior year included a light product release schedule, consisting mainly of titles in the Dungeons & Dragons franchise.

•		Publishing net revenue during the three months ended September 30, 2004 includes international royalties of $1.5 million earned on IESA’s international sales of our titles, primarily DRIV3R, Terminator 3: The Redemption, and Shadow Ops: Red Mercury. The 2003 quarter’s international royalties were minimal.
•		The overall average unit sales price (“ASP”) of the publishing business is up 13.7% from $14.92 to $16.97 due to an increase in console ASP coupled with a mix shift within the publishing business away from PC titles and

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toward higher priced console titles. Console titles made up 72.8% of this quarter’s publishing sales compared with 61.5% last year. Against the prior year’s comparable quarter, console ASP increased 19.2% to $20.52 while PC ASP decreased 5.8% to $11.59.

•

Total distribution net revenues for the three months ended September 30, 2004, decreased approximately $2.2 million or 14.2% from the comparable 2003 period due to our decision to reduce our third party distribution operations in the specific instances where margins were insufficient.

Gross Profit

Platform mix for the three months ended September 30, 2003 and 2004 is summarized below:

          Gross profit increased to $30.4 million for the three months ended September 30, 2004 from $22.6 million in the comparable 2003 period primarily from increased sales volume. Gross profit as a percentage of net revenues increased from 37.4% for the three months ended September 30, 2003 to 42.6% in the comparable 2004 period. This increase is due to:

•

higher ASPs within the publishing business,

•

a reduction in the mix of lower margin third party business from 25.7% in the 2003 quarter to 18.7% in the current quarter, and

•

a lower mix of royalty bearing product. Royalty expense is 13.8% of net revenues in the current quarter compared with 16.1% in the prior year’s comparable quarter.

Selling and Distribution Expenses

          Selling and distribution expenses primarily include shipping, personnel, advertising, promotions and distribution expenses. During the three months ended September 30, 2004, selling and distribution expenses increased approximately $1.6 million, or 11.6%, to $15.4 million (21.5% of net revenues) from $13.8 million (22.8% of net revenues) in the comparable 2003 period. Advertising expenses increased $1.9 million, or 28.1%, in the current period to support the increase in new titles launched this period. Variable distribution costs, including freight, shipping and handling, have increased compared to the 2003 quarter on higher sales.

General and Administrative Expenses

          General and administrative expenses primarily include personnel expenses, facilities costs, professional expenses and other overhead charges. During the three months ended September 30, 2004, general and administrative expenses increased approximately $1.3 million, or 14.8%, to $10.1 million from $8.8 million in the comparable 2003 period from general salary increases, the inclusion of a fully salaried CEO, and increased building maintenance and telecommunications charges. General and administrative expenses as a percentage of net revenues remained relatively consistent, decreasing slightly from 14.6% in the 2003 quarter to 14.2% in the current quarter.

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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 the direct costs of internally developing and producing a title. These expenses for the three months ended September 30, 2004 decreased approximately $4.7 million, or 19.9%, to $18.9 million from $23.6 million in the comparable 2003 period, reflecting a lower number of titles in development and the timing of the milestone completions upon which this expense is based. Additionally, savings over the 2003 quarter were recognized from the closure of the Legend and Minnesota studios during fiscal 2004. Internal research and development expenses represent 50% of the total R&D expenses for the three months ended September 30, 2004 and 37% of the total R&D expenses for the three months ended September 30, 2003. As a percentage of net revenues, expenses decreased to 26.5% for the three months ended September 30, 2004 from 38.9% in the comparable 2003 period.

Depreciation and Amortization

          Depreciation and amortization for three months ended September 30, 2004 increased by $0.6 million, or 30.0%, to $2.6 million from $2.0 million in the comparable 2003 period due primarily to our license with Atari Interactive for the rights to the Atari name.

Interest Expense, net

          Interest expense, net, decreased by $3.2 million to $0.5 million for the three months ended September 30, 2004 from $3.7 million in the comparable 2003 period. The decrease is a result of our September 2003 recapitalization whereby all outstanding related party debt was converted to equity. Since the recapitalization, interest and financing fees have consisted of expenses incurred under our credit facility arrangement with GECC, offset by interest income earned on the related party notes receivable.

Benefit from Income Taxes

          Benefit from income taxes decreased by approximately $0.8 million, or 80.0%, to a benefit of $0.2 million from a benefit of $1.0 million in the 2003 period. The benefits recorded in both quarters resulted from the reversal of the respective prior quarters’ federal and state alternative minimum tax provisions of $0.4 million and $0.9 million. Additionally, during the three months ended September 30, 2004, we recorded a provision of approximately $0.2 million for a potential tax expense at our UK subsidiary.

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          Six months ended September 30, 2004 versus the six months ended September 30, 2003

     Consolidated Statement of Operations (dollars in thousands):

Net Revenues

Net Revenues by Segment (in thousands):

          Net revenues for the six months ended September 30, 2004 decreased approximately $30.2 million or 14.3% from $211.9 million to $181.7 million.

•

Despite the strong DRIV3R launch in June 2004 and the current quarter’s favorable performance over the prior year’s comparable quarter, current year-to-date sales lag the prior year by $22.9 million or 12.7% because of the huge success in the first quarter of 2003 of Enter the Matrix. Year-to-date domestic net sales of DRIV3R are approximately $37.9 million compared with year-to-date domestic net sales of Enter the Matrix in the same period last year of approximately $77.0 million. Other new releases in the current year include Transformers (PlayStation 2), Test Drive: Eve of Destruction (PlayStation 2 and Xbox), Dragon Ball Z: Super Sonic Warriors (Game Boy Advance), Duel Masters: Sempai Legends (Game Boy Advance), Shadow Ops: Red Mercury (Xbox), Dragonball Z: Buu’s Fury (Game Boy Advance), Terminator 3: The Redemption (PlayStation 2, Xbox, and GameCube), Demon Stone (PlayStation 2), and YuYu Hakusho: Dark Tournament (PlayStation 2), which produced net U.S. revenues aggregating approximately $38.8 million.

•		Publishing net revenue during the six months ended September 30, 2004 includes international royalties of $16.3 million earned on IESA’s international sales of our titles. These royalties include income of $14.6 million from international sales of DRIV3R. The comparable 2003 period’s international royalties of $17.3 million were due largely to the success of Enter the Matrix.

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•		The overall ASP of the publishing business is flat with that of the prior year at approximately $20.00. Similarly, the ASP of console and PC titles are unchanged at approximately $24.00 and $13.00, respectively. Platform mix in the current year continues to shift away from PC toward console titles with console accounting for 79.5% of the current year’s publishing sales. The prior period’s publishing business was made up of 73.2% console product.
•		Total distribution net revenues for the six months ended September 30, 2004 decreased approximately $7.3 million or 23.4% from the comparable 2003 period due to our decision to reduce our third party distribution operations in the specific instances where margins were insufficient.

Gross Profit

Platform mix for the six months ended September 30, 2003 and 2004 is summarized below:

          Gross profit decreased to $88.8 million for the six months ended September 30, 2004 from $103.1 million in the comparable 2003 period primarily from decreased sales volume. Gross profit as a percentage of net revenues of 48.7% remained constant, reflecting:

•

flat ASP within the publishing business and

•

a consistent mix of lower margin third party business this year versus last year.

Selling and Distribution Expenses

          Selling and distribution expenses primarily include shipping, personnel, advertising, promotions and distribution expenses. During the six months ended September 30, 2004, selling and distribution expenses decreased approximately $0.9 million, or 2.7%, to $33.0 million (18.2% of net revenues) from $33.9 million (16.0% of net revenues) in the comparable 2003 period. The decrease is due to lower variable distribution costs, including freight, shipping and handling, by $0.8 million, or 14.8%, on lower sales, as well as savings in salaries and related overhead costs from the closure of the Minnesota studio in March 2004. The decrease is partially offset by an increase in advertising expenses by $0.9 million, or 4.8%, in the current period to support more new releases.

General and Administrative Expenses

          General and administrative expenses primarily include personnel expenses, facilities costs, professional expenses and other overhead charges. During the six months ended September 30, 2004, general and administrative expenses increased approximately $0.9 million, or 5.2%, to $18.2 million (10.0% of net revenues) from $17.3 million (8.2% of net revenues) in the comparable 2003 period due to general salary increases and the inclusion of a fully salaried CEO, net of a $1.2 million bonus expense reduction and a $0.3 million litigation reserve reversal by our French subsidiary, both occurring in the prior year’s comparable period. The increase is partially offset by the recognition of a $0.9 million translation gain from the liquidation of the dormant Australian subsidiary in the first quarter of the current year.

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 the direct costs of internally developing and producing a title. These expenses for the six months ended September 30, 2004 decreased approximately $9.8 million, or 21.4%, to $36.0 million from $45.8 million in the comparable 2003 period due to the planned reduction in the number of titles in development with

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external developers. Additional savings over the prior year’s comparable period were recognized from the closure of the Legend and Minnesota studios in fiscal 2004. Internal research and development expenses represent 51% of the total R&D expenses for the six months ended September 30, 2004 and 42% of the total R&D expenses for the six months ended September 30, 2003. Research and development expenses, as a percentage of net revenues, decreased to 19.8% for the six months ended September 30, 2004 from 21.6% in the comparable 2003 period.

Depreciation and Amortization

          Depreciation and amortization for six months ended September 30, 2004 increased by $1.5 million, or 38.5%, to $5.4 million from $3.9 million in the comparable 2003 period due primarily to our license with Atari Interactive for the rights to the Atari name.

Interest Expense, net

          Interest expense, net, decreased by $6.1 million to $0.7 million for the six months ended September 30, 2004 from $6.8 million in the comparable 2003 period. The decrease is a result of our September 2003 recapitalization whereby all outstanding related party debt was converted to equity. Since the recapitalization, interest and financing fees have consisted of expenses incurred under our credit facility arrangement with GECC, offset by interest income earned on the related party notes receivable.

(Benefit from) Provision for Income Taxes

          During the six months ended September 30, 2004, we recorded a provision of approximately $0.2 million for a potential tax expense at our UK subsidiary. The balance of the provision consists principally of state taxes. For the six months ended September 30, 2003, a nominal balance was recorded as a benefit from income taxes.

Liquidity and Capital Resources

Overview

          As of September 30, 2004, management believes that we have sufficient capital resources to finance our 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. However, it is expected that a new generation of video game equipment will be introduced in late 2005 and early 2006. We will have to invest a substantial sum to make our products compatible with this new generation of equipment and to generate an inventory of products for the new equipment. In order to raise that sum, we will have to sell equity or debt or establish new sources of borrowings.

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Cash Flows

(in thousands)

          During the six months ended September 30, 2004, cash of $8.8 million was used for operating activities to increase trade receivables and manage the delayed payments of our related party receivables. The growth in our receivables was partially offset by the decrease of our inventories and an increase in accounts payable and accrued liabilities from tight working capital management. Prior year’s operating activities benefited from the release of Enter the Matrix.

          We saw a decrease in cash used for investing activities from a usage of approximately $17.5 million in the 2003 period to proceeds of $0.1 million in the six months ended September 30, 2004. The primary reason for this decrease is due to the advances made to Atari Interactive of $14.4 million under the terms of the GECC senior credit facility during the 2003 period. No such advances were made in the 2004 period.

          During the six months ended September 30, 2004, our financing activities provided cash of approximately $0.1 million, a decrease of $24.8 million as compared to the 2003 period. This decrease is attributable to the $35.0 million net proceeds received from the public stock offering in the 2003 period, reduced by the 2003 period’s payments under the GECC senior credit facility of $10.7 million. The net use of cash of $8.6 million in the September 2004 period has been funded entirely by the $9.6 million of cash on hand at March 31, 2004. No borrowings are outstanding against the GECC senior credit facility at September 30, 2004; however, $6.1 million of letters of credit were outstanding.

          We expect continued volatility in the use of cash due to seasonality of the business, receivable payment cycles and quarterly working capital needs to finance our publishing businesses and growth objectives.

          Our outstanding accounts receivable balance varies significantly on a quarterly basis due to the seasonality of our business and the timing of new product releases. There were no significant changes in the credit terms with customers during the three month period.

          We do not currently have any material commitments with respect to any capital expenditures. However, we do have commitments to pay royalty and license advances, milestone payments, and operating lease obligations.

          We are also party to certain litigation arising in the course of our business. Management believes that the ultimate resolution of these matters will not have a material adverse effect on our liquidity, financial condition or results of operations.

          Our ability to maintain sufficient levels of cash could be affected by various risks and uncertainties including, but not limited to, customer demand and acceptance of our new versions of our titles on existing platforms and our titles on new platforms, our ability to collect our receivables as they become due, risks of product returns, successfully achieving our product release schedules and attaining our forecasted sales goals, seasonality in operating results, fluctuations in market conditions and the other risks described in the “Risk Factors” as noted in our Annual Report on Form 10-K filed with the Securities and Exchange Commission for the year ended March 31, 2004.

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IESA Liquidity

          IESA has incurred significant continuing losses from operations and is highly leveraged. IESA owns, directly and indirectly, approximately 59% of our stock, distributes our products in Europe, Asia, and certain other regions, and pays us royalties in this respect. IESA also develops products which we distribute in the U.S., Canada, and their territories and possessions, and for which we pay royalties to IESA. As at September 30, 2004, royalty payments due and payable to us by IESA under our existing distribution agreement for the period then ended amounted to approximately $15.7 million. In addition, as at that same date, amounts due and payable to us by Atari Interactive and Paradigm, respectively, amounted to approximately $4.8 million and to $0.8 million, in respect of promissory notes.

          On November 3, 2004, we entered into an agreement with IESA and several of its subsidiaries under which, in lieu of receiving payment on the above past due amounts, we transferred the amounts due to us from IESA and Paradigm to Atari Interactive in exchange for a secured promissory note (the “Secured Note”) from Atari Interactive that also includes in the initial principal amount the sums currently due to us from Atari Interactive and a $1.6 million note payment that would have been due from Atari Interactive on December 31, 2004, and interest on those amounts of approximately $0.1 million. Specifically, the Secured Note has a principal amount of approximately $23.1 million, will mature on March 31, 2005, bears annual interest at the prime rate plus 3.25%, and is secured by 2,000,000 shares of our common stock owned and pledged by Atari Interactive and by the rights, as owner, to the “Atari” trademark and the Fuji logo in North America (collectively, the “Collateral”). The “Atari” trademark and “Fuji” logo currently are owned by Atari Interactive and licensed to us through 2013 under the terms of the Trademark License Agreement, dated September 4, 2003.

          If Atari Interactive fails to pay all outstanding principal and interest it owes to us in respect of the Secured Note when due on March 31, 2005, or if Atari Interactive otherwise defaults on its obligations to us thereunder, we will have the contractual right to foreclose on the Collateral. We have the right to apply royalties we will owe to Atari Interactive or to IESA or other of its subsidiaries in reduction of the Secured Note, instead of paying the royalties. Based on our projected royalty obligations to Atari Interactive, IESA and its other subsidiaries, we anticipate that by March 31, 2005, we will have applied most if not all those amounts against amounts owed to us under the Secured Note.

          In October 2004, IESA entered into an agreement with certain of its bank lenders under which it restructured the repayment terms of its debt obligation to those banks, extending the maturity dates thereof. IESA also entered into arrangements with certain of its banks in order to finance its operations through the upcoming holiday season.

          Although we are not a party to, or a guarantor of, and have no obligations or liability in respect of IESA’s indebtedness to its bank lenders or any of its other creditors, IESA distributes our products in Europe and elsewhere, other than in North America, and both IESA and Atari Interactive are material sources of products which we market in the United States and Canada.

          If IESA is unable to address its liquidity problems and fund its working capital needs through a debt refinancing or by raising equity capital, selling assets or completing a similar transaction, IESA would likely be unable to fund the video game development operations of Atari Interactive, and our results of operations could be materially impaired because our revenue from the distribution of Atari Interactive and IESA products could decrease materially. Such a reduction of our revenues, among other things, could result in a breach of one or more of the covenants contained in our senior credit facility with GECC. If the above contingencies occurred, we probably would be forced to take actions that, could include, but would not necessarily be limited to, a significant reduction in our expenditures for internal and external new product development and the implementation of a comprehensive cost reduction program to reduce our overhead expenses. These actions, should they become necessary, could result in a significant reduction in the size of our operations and could have a material adverse effect on our revenue and cash flows. At present there can be no assurance regarding any of the foregoing contingencies and management will continue to monitor these developments closely.

GECC Senior Credit Facility

          On November 12, 2002 (last amended November 3, 2004), we obtained a 30-month $50.0 million senior credit facility with GECC to fund our working capital and general corporate needs, as well as to fund advances to Atari Interactive and Paradigm, each a related party. Loans under the senior credit facility are based on a borrowing base comprised of the value of our 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 we paid $0.6 million as an initial commitment fee at closing. The senior credit facility contains certain financial covenants and originally named certain related entities, such as Atari Interactive and Paradigm, as guarantors. In addition, amounts outstanding under the senior credit facility are secured by our assets. As of September 30, 2004, no borrowings are outstanding under the senior credit facility; however, $6.1 million of letters of credit were outstanding. As of September 30, 2004, accrued interest of approximately $0.3 million is included in accrued liabilities and we were in compliance with all financial covenants (see IESA Liquidity).

          Under an amendment to the senior credit facility, dated December 23, 2003, Atari Interactive and Paradigm have been removed as guarantors. Furthermore, under the amendment, we are no longer permitted to fund advances to Atari Interactive and Paradigm unless otherwise approved by GECC. All outstanding related party notes receivable have been approved, as well as the renegotiated debt arrangement with Atari Interactive and Paradigm.

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Contractual Obligations

          As of September 30, 2004, royalty and license advance obligations, milestone payments, and future minimum lease obligations under non-cancelable operating leases are summarized as follows (in thousands):

Contractual Obligations
Payments Due by Period

(1)		We have committed to pay advance payments under certain royalty and license agreements. Most of the payments of these obligations are not dependent on the delivery of the contracted services by the developers.
(2)		Milestone payments represent royalty advances to developers for products that are currently in development. Although milestone payments are not guaranteed, we expect to make these payments if all deliverables and milestones are met timely and accurately.
(3)		We account for our leases as operating leases, with expiration dates ranging from 2005 through 2012. These are future minimum annual rental payments required under the leases, including a related party sub-lease with Atari Interactive.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

          Our carrying value of cash, trade accounts receivable, accounts payable, accrued liabilities, royalties payable, related party notes receivable, amounts due to and from related parties and our existing lines of credit are a reasonable approximation of their fair value.

Foreign Currency Exchange Rates

          We earn royalties on sales of our product sold internationally. These revenues, which are based on various foreign currencies and are billed and paid in U.S. dollars, represented $16.3 million of our revenue for the six months ended September 30, 2004. We do not hedge against foreign exchange rate fluctuations due to the limited financial exposure we face with respect to such risk. We purchase certain of our inventories from foreign developers. We also pay royalties primarily denominated in euros to IESA from the sale of IESA products in North America. Our 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. Our future results could be materially and adversely impacted by changes in these or other factors. As of September 30, 2004, foreign subsidiaries represented 0.0% and 1.3% of consolidated net revenues and total assets, respectively. We also recorded approximately $5.4 million in operating expenses attributed to foreign operations related primarily to a development studio located outside the United States. Currently, substantially all of our business is conducted in the United States where revenues and expenses are transacted in U.S. dollars. As a result, the majority of our results of operations are not subject to foreign exchange rate fluctuations.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures. As of September 30, 2004, with the participation of our management, our Chief Executive Officer and Acting Chief Financial Officer evaluated our 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 our disclosure controls and procedures, management recognizes 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, our Chief Executive Officer and Acting Chief Financial Officer concluded that as of September 30, 2004, our disclosure controls and procedures were (1) designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to our Chief Executive Officer and Acting 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 us in the reports that we file or submit 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.

Changes in Internal Control over Financial Reporting. No change in our 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 September 30, 2004, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

          During the six months ended September 30, 2004, no significant claims were asserted against or by us that, in management’s opinion, the likely resolution of which would have a material adverse affect on our liquidity, financial condition or results of operations, although we are involved in various claims and legal actions arising in the ordinary course of business. The following is a summary of pending litigation matters. With respect to matters in which we are the defendant, we believe that the underlying complaints are without merit and intend to defend ourselves vigorously.

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

Knight Bridging Korea v. Infogrames, Inc. et al.

          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 us in Superior Court of California, Orange County (the “Court”). KBK alleges that on or about December 15, 2001, KBK entered into a contract with Gamesonline to obtain the right to localize and distribute electronically in Korea, Neverwinter Nights and certain back list games. The complaint further alleges that Gamesonline and we conspired to prevent KBK from entering the market with Neverwinter Nights or any back title of Gamesonline. The complaint alleges the following causes of action against us: 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 us, adding Atari Interactive (f/k/a Infogrames Interactive, Inc.) as a named defendant, and alleging that we managed and directed Atari Interactive to engage in the foregoing alleged acts. We 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 defendants Does 2, 3 and 4 as “Infogrames Asia Pacific”, “Infogrames Korea” and “Interplay, Inc.”, respectively. On October 29, 2003, Interplay filed a cross-complaint against us, Atari Interactive, Infogrames Korea and Roes 101 through 200. We and Atari Interactive filed an answer on December 3, 2003. On March 25, 2004, KBK filed a Second Amended Complaint for Damages adding new causes of action for fraud against Gamesonline and Interplay; seeking rescission of the Electronic Distribution Agreement between KBK and Gamesonline; for “breach of third party beneficiary rights” against Atari Interactive; for unlawful restraint of trade against all defendants; for RICO Act violations against all defendants; and for civil conspiracy against all defendants; and adds allegations of alter ego status between Gamesonline and Interplay and as between us, Atari Interactive, and Atari Korea. Discovery is ongoing.

          On March 10, 2004, the Court entered a stipulation among the parties referring the matter to a private judge. The private judge, retired Superior Court Judge Harvey Schneider, will be presiding over all aspects of the case, including the non-jury trial.

          We and Atari Interactive prevailed on a Motion for Leave to File a Cross-Complaint against Interplay and Gamesonline. We and Atari Interactive also prevailed on a Motion for Summary Adjudication on the RICO Act claim.

          On July 1, 2004, KBK filed a Third Amended Complaint whereby certain previous allegations were either omitted or clarified as a result of the Court’s rulings at the June 17, 2004 hearings.

          KBK has purported to serve in Korea an entity it called “Atari Korea” with a Summons and Complaint in this case. Atari Korea Ltd. filed a Motion to Quash Service based on failure to comply with the terms of the Hague Convention and/or lack of personal jurisdiction over that entity. This motion was granted.

          On or about October 1, 2004, KBK’s litigation counsel resigned. On October 8, 2004, we and Atari Interactive filed an ex parte application to strike KBK’s pleadings or, in the alternative, for an order shortening the time to hear such

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application as noticed motions. The ex parte application was heard and denied on October 11, 2004 but the Court did grant the application for a shortened period of time to hear such application as noticed motions. On October 19, 2004, the Court granted our Motion to Strike KBK’s Pleadings due to the fact that KBK has no counsel to represent it in the litigation and did not file any opposition to the motion. The Court dismissed KBK’s complaint without prejudice. The cross-claims have not been dismissed by the other parties to the litigation. We and Atari Interactive are in discussions with the other parties with respect to same.

Atari, Inc., Atari Interactive, Inc., and Hasbro, Inc. v. Games, Inc., Roger W. Ach, II , and Chicago West Pullman LLC

          On May 17, 2004, we and Atari Interactive together with Hasbro filed a complaint against Games, its CEO, Ach, and Chicago West Pullman in the United States District Court for the Southern District of New York and sought a temporary restraining order and preliminary injunction to stop Games’ and Ach’s use of certain trademarks and copyrights owned by Atari Interactive and Hasbro. The plaintiffs allege that an interim license that we granted to Games for the development and publication of certain games in a specified online format expired by its terms when Games failed to pay us certain fees by April 30, 2004, pursuant to an Asset Purchase, License and Assignment Agreement between us and Games dated December 31, 2003, as amended (the “Agreement”). The plaintiffs allege that Games’ failure to pay voided an expected transfer of the “games.com” domain name and certain web site assets from us to Games and constituted a breach of contract and that Chicago West Pullman’s failure to pay constituted a breach of guarantee. The plaintiffs further allege that upon the expiration of the interim license, all intellectual property rights granted under that license reverted back to us, but that Games nevertheless continued to use the plaintiffs’ intellectual property. On May 18, 2004, the Court granted a temporary restraining order against Games and Ach and scheduled a preliminary injunction hearing for May 28, 2004, which was postponed until June 11, 2004. Prior to that hearing, Games’ agreed to the preliminary injunction and the Court signed an order granting the preliminary injunction pending the outcome of the case.

          On June 16, 2004, Games served its Answer and Counterclaim to the complaint. In its counterclaim, Games alleges that the plaintiffs breached the Agreement and a Settlement Agreement dated March 31, 2004 by, inter alia, licensing other web sites to use on-line play of certain Atari and Hasbro games that Games claimed were part of its exclusive license under the Agreement.

          On June 23, 2004, the Court ordered that the parties attend a case management conference scheduled for June 29, 2004. At the June 29, 2004, case management conference, Games’ counsel raised issues relating to the plaintiffs’ failure to respond to its discovery requests. The Court directed that the plaintiffs submit a letter brief setting forth its generic objections to Games’ discovery requests. The Court ordered that the plaintiffs’ letter brief be submitted by July 6, 2004 and that Games submit its reply by July 13, 2004. The Court also scheduled a teleconference for July 14, 2004. On July 6, 2004, the plaintiffs submitted their letter brief to the Court and also served Games with its Rule 26(a)(1) initial disclosures and answer to the counterclaim.

          Games’ counsel failed to appear for the July 14, 2004, teleconference and it was adjourned to July 15, 2004. At that teleconference, the Court granted the majority of the plaintiffs’ motion to quash Games’ discovery requests. As a result of the Court’s ruling, the plaintiffs do not have to produce any documents that were created on or before March 31, 2004, any documents relating to derivative games, or any documents relating to any license agreements with third parties concerning derivative games, downloads, or streaming.

          On July 16, 2004, it came to the plaintiffs’ attention that, in flagrant violation of the preliminary injunction, Games had issued a press release on July 13, 2004, that erroneously stated that Games owned the “games.com” web site and that it had an exclusive license to certain Atari and Hasbro games. The plaintiffs immediately brought the erroneous press release to the attention of Games’ counsel. On that same day, Games replaced the erroneous press release with a corrected press release, but refused to issue a corrective press release explaining that it in fact did not own either the web site or have any license to Atari and Hasbro games. On July 19, 2004, the plaintiffs brought this to the attention of the Court, who ordered that a corrective press release be issued, but approved language submitted by Games’ counsel.

          On September 3, 2004, in a teleconference with the Court, Games requested from the Court that the plaintiffs be ordered to produce agreements with third parties from the first quarter of 2004 concerning online play of certain Atari and Hasbro games. During that same teleconference, the plaintiffs sought permission to move to dismiss the counterclaims against Atari Interactive and Hasbro. On September 8, 2004, the Court broadened the scope of discovery to include documents regarding contracts and negotiations between us and Hasbro and third parties between January 1, 2004 and March 31, 2004 regarding online play of the original classic versions of the games. The Court also set a schedule for the plaintiffs’ motion to dismiss the Counterclaims, which has been fully submitted and is under judicial deliberation.

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          On October 4, 2004, it came to the plaintiffs’ attention that, once again, Games was in flagrant violation of the preliminary injunction because it represented in its Form 10-KSB filing dated October 1, 2004, that Games owned the domain name “games.com” and that it had an exclusive license to certain Hasbro and Atari games. The plaintiffs immediately brought this to the attention of Games’ counsel, who represented that certain, but not all, statements would be amended. But Games did not amend its Form 10-KSB. Accordingly, the plaintiffs sought permission to move for contempt for violation of the preliminary injunction.