UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For the quarterly period ended December 31, 2004

OR

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

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).

     As of February 7, 2005, there were 121,294,592 of the registrant’s Common Stock outstanding.

ATARI, INC. AND SUBSIDIARIES
DECEMBER 31, 2004 QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

ATARI, INC. AND SUBSIDIARIES

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

Page 3

ATARI, INC. AND SUBSIDIARIES

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

Page 4

ATARI, INC. AND SUBSIDIARIES

Page 5

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

Page 6

ATARI, INC. AND SUBSIDIARIES

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

Page 7

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 December 31, 2004, IESA owns approximately 61% 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”). As of the date of this filing, IESA’s ownership has been reduced to approximately 52% (see Note 7).

     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”, eliminated 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

Page 8

not result in any impairment of goodwill or intangibles. As of December 31, 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 $0.9 million, net of accumulated amortization of $1.3 million and $1.8 million at March 31, 2004 and December 31, 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.

     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 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

          Licenses for intellectual property are capitalized as assets upon the execution of the contract when no significant obligation of performance remains with the third party. If significant obligations remain, the asset is capitalized when payments are due as opposed to when the contract is executed. These licenses are amortized at the licensor’s royalty rate over unit sales. Management evaluates the carrying value of these capitalized licenses and records an impairment charge (as research and development expense) in the period management determines that such capitalized amounts are not expected to be realized.

     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 an estimated realizable amount. We monitor our tax liability on an estimated

Page 9

quarterly basis and record the estimated tax obligation based on our current year-to-date taxable income and expectations of the full year results.

     Income (Loss) Attributable to Common Stockholders Per Share

          Basic income (loss) attributable to common stockholders per share is computed by dividing income (loss) attributable to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted income (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. The following is a reconciliation of basic and diluted income (loss) attributable to common stockholders per share (in thousands, except per share data):

          The number of antidilutive shares that was excluded from the diluted earnings per share calculation for the three months and nine months ended December 31, 2003 was 7,034,000 and 13,019,000, respectively. The number of antidilutive shares that was excluded from the diluted earnings per share calculation for the three months and nine months ended December 31, 2004 was 8,889,000 and 6,766,000, respectively. For the three months ended December 31, 2003 and the three months and nine months ended December 31, 2004, the antidilutive shares result from stock options and warrants in which the exercise price is greater than the average market price of the common shares during the period. For the nine months ended December 31, 2003, the shares were antidilutive due to the loss attributable to common stockholders for the period.

     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

Page 10

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 December 31, 2004, we had three stock option plans. No compensation cost is reflected in net income 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 income (loss) attributable to common stockholders and income (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 nine months ended December 31, 2003 and 2004 was determined using the Black-Scholes option pricing model utilizing the following assumptions:

     Recent Accounting Pronouncements

          In December 2004, the FASB issued Statement No. 123 (revised 2004), “Share-based Payment”, which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. Statement 123(R) supersedes APB No. 25, “Accounting for Stock Issued to Employees”, and amends FASB Statement No. 95, “Statement of Cash Flows”. Generally, the approach to accounting in Statement 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements as based on their fair values. Currently we account for these payments under the intrinsic value provisions of APB No. 25 with no expense recognition in the financial statements. Statement 123(R) is effective for quarters beginning after June 15, 2005. The Statement offers several alternatives for implementation. At this time, management has not made a decision as to the alternative it may select.

          In November 2004, the FASB issued Statement No. 151, “Inventory Costs”, an amendment of APB No. 43, Chapter 4. The amendments made by Statement No. 151 will improve financial reporting by requiring that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) be recognized as current-period charges and by requiring the allocation of fixed production overheads to inventory based on the normal capacity of

Page 11

production facilities. Statement No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 24, 2004. We have determined that adoption of SFAS No. 151 will have no material effect on our financial position and results of operations.

NOTE 2 – RECAPITALIZATION AND OTHER CORPORATE MATTERS

          During September 2003, we entered into a series of transactions to restructure our debt and equity through a recapitalization of debt (“Recapitalization”) and a 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”).

     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 December 31, 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 had $8.6 million in related party notes receivable outstanding at March 31, 2004, which arose after the Recapitalization and are related to certain other transactions. In November 2004, we converted the remaining outstanding portion of these notes in addition to $15.7 million of related party royalty receivables into a secured promissory note, which, as of December 31, 2004, was approximately $20.8 million (see Note 6). These notes are permitted by the GECC senior credit facility (see Note 9).

          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 December 31, 2004, $3.4 million of this deferred charge is included in Prepaid Expenses and Other Current Assets with the remaining $0.8 million, net of $4.3 million of amortization, included in Other Assets. As part of the secured promissory note due from Atari Interactive entered into in November 2004 (see Note 6), the 2,000,000 shares have been pledged as collateral should Atari Interactive default on payment of the secured promissory note.

     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.

Page 12

NOTE 3 – RECEIVABLES, NET

          Receivables consist of the following (in thousands):

NOTE 4 – INVENTORIES, NET

          Inventories consist of the following (in thousands):

NOTE 5 – ACCRUED LIABILITIES

          Accrued liabilities consist of the following (in thousands):

NOTE 6 – RELATED PARTY TRANSACTIONS

Related Party Notes Receivable

          On March 31, 2004, Atari Interactive and Paradigm, respectively, issued to us related party notes receivable (as described in (1) and (2) below) which bore interest, prior to default, at prime plus 1.25%.

          As of September 30, 2004, Atari Interactive and Paradigm had 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 the renegotiated terms, see below.

Page 13

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

(1) This note was 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. The outstanding balance of this note as of September 30, 2004 was $3.8 million, of which $2.2 million was past due. The outstanding balance was converted to a secured promissory note from Atari Interactive on November 3, 2004 (see (3) below).

(2) The Atari Interactive note and the Paradigm note were payable on September 30, 2004. The balance of the Atari Interactive note was converted to a secured promissory note. The balance of the Paradigm note was assigned to Atari Interactive and subsequently transferred to a secured promissory note from Atari Interactive on November 3, 2004 (see (3) below).

(3) As at September 30, 2004, royalty payments past due to us by IESA under our existing distribution agreement (see Royalty Agreement below) for the period then ended amounted to approximately $15.7 million. In addition, as at that same date, amounts past due to us by Atari Interactive and Paradigm, respectively (see above), amounted to approximately $4.8 million and to $0.8 million, in respect of related party notes receivable (see (1) and (2) above).

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 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 past 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 for specific uses (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 (see Note 2). The Secured Note allows for the netting of sums currently due to us with IESA and several of its subsidiaries. As of December 31, 2004, a net related party payable balance of $2.6 million was netted against the Secured Note, offset by interest income of $0.3 million added to the Secured Note. As of December 31, 2004, we have approximately $22.4 million due to IESA and certain of its subsidiaries, which we may offset against amounts outstanding under the Secured Note. Based on our projections of amounts payable to Atari Interactive, IESA, and certain of its other subsidiaries, we anticipate that on March 31, 2005, the Secured Note will be repaid through the offset of those amounts.

          For the three months and nine months ended December 31, 2004, $0.1 million and $0.3 million, respectively, of interest income has been earned on the related party notes receivable with Atari Interactive and Paradigm. This interest was outstanding as of November 3, 2004 and was consolidated into the Secured Note. Subsequent to November 3, 2004, $0.3 million of interest income was earned on the Secured Note and was added to the outstanding Secured Note balance.

Page 14

     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.

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

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.

Gain on sale of development project to a related party

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

Page 15

NOTE 7 – PARENT LIQUIDITY

     As of the date of this report, IESA beneficially owns, directly and indirectly, approximately 52% of our stock. IESA has incurred significant continuing operating losses and is highly leveraged. IESA has taken steps to improve its financial situation, including, (i) restructuring its outstanding debt obligations such that the debt amount is reduced and the debt maturity schedule is more favorable, (ii) reducing operating expenses, (iii) raising capital by selling (through CUSH) 11,000,000 of its shares in Atari, pursuant to a registration statement, (iv) entering into banking arrangements to fund operations and position itself for the new hardware cycle, (v) selling assets, such as its rights in the Civilization franchise, and (vi) entering into production fund agreements to finance certain game development projects. However, IESA has not yet completed all of the actions it plans to take in order to improve its operations and reduce its debt. As a result, IESA's current ability to, among other things, fund its subsidiaries' operations is diminished. There can be no assurance that IESA will complete such actions to assure its future financial stability.

     If IESA is unable to complete its action plan and address its liquidity problems and fund its working capital needs, IESA would likely be unable to fund its and its subsidiaries' video game development operations, including that of Atari Interactive. Pursuant to our GECC senior credit facility, we are prohibited from making advances to Atari Interactive. Therefore, our results of operations could be materially impaired if IESA fails to fund Atari Interactive, as any delay or cessation in product development could materially decrease our revenue from the distribution of Atari Interactive and IESA products. 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.

     IESA 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. Both IESA and Atari Interactive are material sources of products which we market in the United States and Canada. Atari Interactive is the source of approximately 31% of our net revenue and we generate approximately 5% of our net revenue from royalties on IESA’s distribution of our products in Europe, Asia, and certain other regions. Also, pursuant to the Secured Note payable as of March 31, 2005, as detailed in Note 6 above, at December 31, 2004, Atari Interactive owes us approximately $20.8 million (subject to further interest accrual and nettings). As of December 31, 2004, we have approximately $22.4 million due to IESA and certain of its subsidiaries, which we may offset against amounts outstanding under the Secured Note. Based on our projections of amounts payable to Atari Interactive, IESA, and certain of its other subsidiaries, we anticipate that on March 31, 2005, the Secured Note will be repaid through the offset of those amounts.

     Additionally, though Atari is a separate and independent legal entity and we are not a party to, or a guarantor of, and have no obligations or liability in respect of, IESA’s indebtedness, because IESA owns the majority of our stock, potential investors and current and potential business/trade partners may view IESA’s financial situation as relevant to an assessment of Atari. Therefore, if IESA is unable to address its financial issues, it may taint our relationship with our suppliers and distributors, damage our business reputation, and otherwise impair our ability to raise and generate capital. IESA continues to focus on ways to address and improve its financial situation.

NOTE 8 – COMMITMENTS AND CONTINGENCIES

Litigation

     During the nine months ended December 31, 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

Page 16

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.

     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

Page 17

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.

     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. The Court ordered that all discovery be completed by November 12, 2004, that opening briefs on summary judgment be filed by November 29, 2004, that answering papers be filed on December 13, 2004, and that reply papers be filed on December 20, 2004. The parties completed discovery, and the plaintiffs filed their motion for summary judgement and motion for contempt sanctions, on November 29, 2004. The Court held oral argument on these motions on January 12, 2005 and we await the Court’s decision.

Page 18

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 did not answer the Complaint and did not respond to the Preliminary Injunction Motion. On December 14, 2004 the case was settled, with the parties executing a Settlement Agreement and the court entering a Final Judgment and Permanent Injunction. Pursuant to the settlement, 321 Studios agreed to permanently cease manufacturing, distributing and selling Games X Copy software. The litigation and settlement was coordinated by the ESA (the Entertainment Software Association) and the costs associated therewith were paid by the ESA.

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, Take-Two Interactive Software, Inc., Ubi Soft, Activision Inc., THQ, Inc., Vivendi, 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. We filed our answer to such complaint on November 8, 2004. Discovery is ongoing.

iEntertainment Network, Inc. v. Epic Games, Inc., Atari, Inc., Valve Corporation, Sierra Entertainment, Inc., Sony Corporation of Japan, Sony Corporation of America, Sony Computer Entertainment America, Inc. and Sony Online Entertainment, Inc.

     On December 22, 2004, we were served with a complaint by iEntertainment, Inc. The complaint has been filed in the United States District Court of the Eastern District of North Carolina Western Division (5:04-CV-647-BD(1)) and names the following defendants: us, Epic Games, Inc., Valve Corporation, Sierra Entertainment, Inc., Sony Corporation of Japan, Sony Corporation of America, Sony Computer Entertainment America, Inc. and Sony Online Entertainment, Inc. The complaint alleges infringement of US Patent No. 6,042,477 (method of and system for minimizing the effects of time latency in multiplayer electronic games played on interconnected computers) and seeks unspecified damages. We intend to answer the complaint.

Codemasters, Inc. v. Atari, Inc.

     On January 13, 2005, we were served with a Complaint by Codemasters, Inc. (“Codemasters”). The complaint has been filed in New York Supreme Court, County of New York. The causes of action arise out of contractual disputes regarding payments owed by each party to the other. Codemasters’ causes of action include breach of contract, failure to respond to submitted statements of account and unjust enrichment. Codemasters is seeking relief in the amount of $931,050.09 and such other relief as may be just and proper, including interests, costs associated with the suit. We intend to answer the complaint.

NOTE 9 – DEBT

Credit Facilities

     GECC Senior Credit Facility

     On November 12, 2002 (last amended January 12, 2005), 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

Page 19

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 December 31, 2004, no borrowings or letters of credit are outstanding under the senior credit facility. As of December 31, 2004, a nominal amount of accrued interest is included in accrued liabilities and we were in compliance with all financial covenants, as amended.

     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 (see Note 6).

     As currently projected, we will be in breach of our fourth quarter financial covenants under the senior credit facility. We plan to secure all necessary waivers or amendments prior to the filing of our March 31, 2005 annual report. However, no assurance can be given that all necessary waivers or amendments will be secured in a timely manner, if at all.

     The senior credit facility expires on May 12, 2005 (if not otherwise extended). We plan to secure an equivalent credit arrangement with either GECC or another lender. However, no assurance can be given that another facility will be secured in a timely manner, if at all, or on terms acceptable to us.

NOTE 10 – 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 December 31, 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 nine months ended December 31, 2003 and 2004 (in thousands):

Page 20

NOTE 11 – INCOME TAXES

     As of December 31, 2004, we have combined net operating loss carryforwards of approximately $452.3 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 it is more likely than not that such asset will not be realized. Management reassesses its position with regard to the valuation allowance on a quarterly basis.

     During the nine months ended December 31, 2004, we recorded a provision of approximately $0.2 million for a potential tax expense related to our UK subsidiary, and the remaining balance consists principally of provisions for state and federal alternative minimum taxes. For the nine months ended December 31, 2003, a provision for income taxes of $0.1 million was recorded.

NOTE 12 – ODDWORLD TRANSACTION

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

     As part of the transaction, we amended our existing Microsoft/Oddworld License Agreement, which, among other things, provided that we retain, without any ongoing obligations, $3.5 million of non-refundable publishing royalties previously advanced by Microsoft. The foregoing transactions resulted in the recognition of $3.5 million of royalties which were previously deferred and an impairment charge on the disposition of our preferred stock investment in Oddworld of $1.7 million. The charge was included in Other (Expense) Income and the royalty was included in net revenues in the accompanying Consolidated Statement of Operations for the three months and nine months ended December 31, 2003.

NOTE 13 – SUBSEQUENT EVENTS

     On February 9, 2005, we announced the closure of our publishing studios located in Santa Monica, California and Beverly, Massachusetts, and the relocation of the functions handled by those studios to our corporate headquarters in New York. We anticipate recording a restructuring reserve during our fiscal 2005 fourth quarter to reflect severance packages, lease obligations and other related items.

Page 21

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 25.6%, 12.3%, 10.2% and 7.2%, respectively, of net revenues for the nine months ended December 31, 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.

Company Reorganization

     On February 9, 2005, we announced the decision to redefine our cost structure with a stronger emphasis on product development and marketing. As a result, we are closing our publishing studios located in Santa Monica, California and Beverly, Massachusetts, and will relocate the functions handled by those studios to our corporate headquarters in New York. We are also assessing our asset portfolio and anticipate divestitures of certain non-core assets. We anticipate that the closures, recent senior management changes and potential divestitures will result in a reduction in annualized general and administrative expenses. We also expect to record a restructuring reserve during our fiscal 2005 fourth quarter to reflect severance packages, lease obligations and other related items.

Page 22

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 December 31, 2003 and 2004, we recorded allowances for bad debts, returns, price protection and other customer promotional programs of approximately $36.3 million and $31.6 million, respectively. For the nine months ended December 31, 2003 and 2004, we recorded allowances for bad debts, returns, price protection and other customer promotional programs of approximately $87.2 million and $72.7 million, respectively. As of March 31, 2004 and December 31, 2004, the aggregate reserves against accounts receivables for bad debts, returns, price protection and other customer promotional programs were approximately $36.3 million and $37.8 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 December 31, 2003 and 2004, we recorded obsolescence expense of approximately $0.3 million and $0.6 million, respectively. For the nine months ended December 31, 2003 and 2004, we recorded obsolescence expense of approximately $0.9 million and $1.7 million, respectively. As of March 31, 2004 and December 31, 2004, the aggregate reserve against inventories was approximately $2.1 million in each period.

External developer royalty advances and milestone payments

     Rapid technological innovation, shelf-space competition, shorter product life cycles and buyer selectivity have made it difficult to determine the likelihood of individual product acceptance and success. As a result, we follow the policy of expensing external developer royalty advances (milestone payments) 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.

Page 23

Licenses

     Licenses for intellectual property are capitalized as assets upon the execution of the contract when no significant obligation for performance remains with the third party. If significant obligations remain, the asset is capitalized when due as opposed to when the contract is executed. These licenses are amortized at the licensor’s royalty rate over unit sales. Management evaluates the carrying value of these capitalized licenses and records an impairment charge (as research and development expense) in the period management determines that such capitalized amounts are not expected to be realized.

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 December 31, 2004, we have combined net operating loss carryforwards of approximately $452.3 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 it is more likely than not that such asset will 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.

Page 24

Results of operations

     Three months ended December 31, 2004 versus the three months ended December 31, 2003

Consolidated Statement of Operations (dollars in thousands):

Net Revenues

Net Revenues by Segment (in thousands):

     Net revenues for the three months ended December 31, 2004 decreased approximately $28.8 million or 15.1% from $190.6 million to $161.8 million.

	•	The current quarter’s net revenues were influenced by several events in the marketplace including the release of premium priced titles by competitors, a shortage of console hardware in the marketplace, and continued contraction of the children’s segment. New releases in the current quarter generated net U.S. revenues aggregating approximately $90.8 million and included Dragonball Z: Budokai 3 (PlayStation 2), Roller Coaster Tycoon 3 (PC), Godzilla: Save the Earth (PlayStation 2 and Xbox), Atari Anthology (PlayStation 2 and Xbox), Sid Meier’s Pirates! (PC), and Atari Flashback, a plug and play classic game console.
	•	Publishing net revenue during the three months ended December 31, 2004 includes international royalty income of $0.7 million earned on IESA’s international sales of our titles. The 2003 quarter’s international royalty income of $10.0 million included royalties earned on Terminator 3 and Mission Impossible, while fewer Atari, Inc. titles were released during the current quarter.
	•	The overall average unit sales price (“ASP”) of the publishing business is up 5.6% from $18.63 to $19.68 due to:

°

the inclusion of Atari Flashback units, which have an average sales price of approximately $30.00 per unit,

Page 25

	°	an improvement in the ASP of PC titles from $12.41 to $16.49, offset by
	°	a decrease in console ASP from $23.09 to $21.54, and
	°	a mix shift within the publishing business toward lower priced PC product. This quarter’s mix consisted of 59.5% console product, 30.9% PC product, and 9.6% Atari Flashback product. The prior year’s comparable quarter’s mix consisted of 72.1% console product and 27.9% PC product.

•

Total distribution net revenues for the three months ended December 31, 2004, increased approximately $2.3 million or 14.0% from the comparable 2003 period on strong sales of productivity software.

Gross Profit

Platform mix for the three months ended December 31, 2003 and 2004 is summarized below:

     Gross profit decreased to $72.1 million for the three months ended December 31, 2004 from $96.7 million in the comparable 2003 period primarily from decreased sales volume. Gross profit as a percentage of net revenues decreased from 50.7% for the three months ended December 31, 2003 to 44.6% in the comparable 2004 period. This decrease in margin is due to:

	•	a lower mix of international royalty income on which we incur no costs,
	•	an increased mix of lower margin third party business (11.4% in the current quarter as compared to 8.5% in the prior year’s comparable quarter), and
	•	a higher mix of royalty bearing product in the current period. Royalty expense is 17.9% of net U.S. revenues in the current quarter compared with 16.0% 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 December 31, 2004, selling and distribution expenses decreased approximately $16.7 million, or 44.8%, to $20.6 million (12.7% of net revenues) from $37.3 million (19.6% of net revenues) in the comparable 2003 period due to:

	•	significantly decreased advertising spending ($13.5 million in the current period compared with $28.6 million in the prior year’s comparable period) due to stricter rationalization of advertising funds and fewer new titles released, and
	•	reduced variable distribution costs, including freight, shipping and handling, due to lower 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 December 31, 2004, general and administrative expenses increased approximately $2.1 million, or 25.9%, to $10.2 million from $8.1 million in the comparable 2003 period due to:

Page 26

	•	higher professional fees,
	•	a lower bonus reversal in the current period as compared with the prior period, and
	•	general salary increases and the inclusion of a fully salaried chief creative officer and chief executive officer costs.

General and administrative expenses increased as a percentage of net revenues from 4.2% in the 2003 quarter to 6.3% in the current quarter.

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, the direct costs of internally developing and producing a title, and billings from related party developers. These expenses for the three months ended December 31, 2004 decreased approximately $8.4 million, or 31.2%, to $18.5 million from $26.9 million in the comparable 2003 period due to:

	•	a planned reduction in the number of titles in development with external developers, and
	•	savings over the 2003 quarter due to the closure of the Legend and Minnesota studios during fiscal 2004, offset partially by
	•	increased spending for certain projects currently in development at our internal studios.

Internal research and development expenses represent 45.9% of the total R&D expenses for the three months ended December 31, 2004 and 32.4% of the total R&D expenses for the three months ended December 31, 2003. As a percentage of net revenues, expenses decreased to 11.4% for the three months ended December 31, 2004 from 14.1% in the comparable 2003 period.

Gain on Sale of Development Project

     During the third quarter of the prior year, we sold a development project to Atari Interactive for $3.7 million resulting in a gain of an equal amount. The sales price to Atari Interactive was equal to the development costs incurred by us, which were expensed during the period of development. The sale was initiated as a result of concerns expressed by the original third party licensor relating to our development efforts. No such gain was recorded in the current period.

Depreciation and Amortization

     Depreciation and amortization for three months ended December 31, 2004 increased by $0.3 million, or 10.7%, to $3.1 million from $2.8 million in the comparable 2003 period. This increase is due to new assets being put into service since the prior year’s comparable period.

Interest (Expense) Income, net

     Net interest expense decreased by $0.6 million from $0.5 million in the prior year’s comparable period to income of $0.1 million for the three months ended December 31, 2004 due to:

	•	reduced interest expense on the GECC senior credit facility on lower borrowings for the current quarter, and
	•	the inclusion of $0.4 million of interest income on the related party notes receivable and the Secured Note (see Note 6).

Other (Expense) Income

     In the prior year’s comparable period, we recorded a $1.8 million write down of an investment to reflect the termination of an arrangement to publish certain titles. No significant items have been recorded in the current period.

Page 27

Provision for Income Taxes

     Provision for income taxes increased by approximately $0.3 million in the current period to $0.4 million from $0.1 million in the comparable 2003 period. The current quarter’s tax provision consists of provisions for federal and state alternative minimum taxes; no alternative minimum taxes were recorded in the prior year’s comparable period since we had expected to be in a break-even position for the full fiscal 2004 year.

Page 28

     Nine months ended December 31, 2004 versus the nine months ended December 31, 2003

Consolidated Statement of Operations (dollars in thousands):

Net Revenues

Net Revenues by Segment (in thousands):

     Net revenues for the nine months ended December 31, 2004 decreased approximately $59.1 million or 14.7% from $402.5 million to $343.4 million.

	•	Our decrease in net sales is largely a function of the current year’s highly competitive holiday season and the recent hardware shortage during the industry’s key period compounded by Atari’s hugely successful launch in the first quarter of the prior year of Enter the Matrix.
	•	New releases in the current quarter as well as the successful launch of DRIV3R in June 2004 have generated net publishing revenues of $301.0 million for the nine months ended December 31, 2004. Year-to-date domestic net revenues on DRIV3R are approximately $38.6 million compared with year-to-date domestic net revenues of Enter the Matrix in the same period last year of approximately $84.1 million. Other new releases in the current year included Dragonball Z: Budokai 3 (PlayStation 2), Roller Coaster Tycoon 3 (PC), Transformers (PlayStation 2), Duel Masters: Sempai Legends (PlayStation 2 and Game Boy Advance), Dragonball Z: Buu’s Fury (Game Boy Advance), Dragon Ball Z: Super Sonic Warriors (Game Boy Advance), Atari Anthology (PlayStation 2 and Xbox), and Atari Flashback, a plug and play classic game console.
	•	Publishing net revenue during the nine months ended December 31, 2004 includes international royalty income of $17.0 million earned on IESA’s international sales of our titles. These royalties include income of $14.9 million