UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the Quarterly Period Ended September 30, 2004

OR

Commission File Number 0-23137

REALNETWORKS, INC.

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

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

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

The number of shares of the registrant’s Common Stock outstanding as of October 24, 2004 was 169,807,353.

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TABLE OF CONTENTS

RealNetworks, Inc.

FORM 10-Q

FOR THE QUARTER ENDED September 30, 2004

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements

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

See accompanying notes to unaudited condensed consolidated financial statements

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

See accompanying notes to unaudited condensed consolidated financial statements

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

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) Description of Business

     RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading global provider of network-delivered digital media products and services. The Company also develops and markets software products and services that enable the creation, distribution and consumption of digital media, including audio and video.

     Inherent in the Company’s business are various risks and uncertainties, including the limited operating history of certain of its product and service offerings and the limited history of premium subscription services on the Internet. The Company’s success will depend on the acceptance of the Company’s technology and services and the ability to generate related revenue.

(b) Basis of Presentation

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

     These financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of the Company’s management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2004. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.

     These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

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

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

     Restricted cash equivalents at September 30, 2004 represent (a) cash equivalents pledged as collateral against a $10.0 million letter of credit in connection with a lease agreement for the Company’s corporate headquarters, (b) cash equivalents pledged as collateral against a $7.3 million letter of credit with a bank which represents collateral on the lease of a building located near the Company’s corporate headquarters, (c) cash equivalents of $2.75 million pledged as collateral against guaranteed minimum payments under a discontinued content agreement, and (d) $0.1 million pledged as collateral in connection with credit agreements with certain financial institutions.

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

     The Company has classified as available-for-sale all marketable debt and equity securities for which there is a determinable fair market value and on which the Company has no restrictions to sell within the next 12 months. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a component of shareholders’ equity, net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income (expense), net. The cost basis for determining realized gains and losses on available-for-sale securities is determined using the specific identification method.

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(d) Notes Receivable from Related Parties and Shareholder

     Notes receivable from related parties consist of loans made in 2000 by Listen.com, Inc. (Listen) to certain former officers of Listen. The notes are limited recourse and bear interest at rates ranging from 6.13% to 6.60% and are due between February 2005 and September 2005.

     Notes receivable from shareholder consist of a full recourse note issued as consideration for the exercise of Listen stock options by a certain former employee of Listen in 1999 that is a current employee of the Company. The note bears interest at a rate of 5.28% and is due seven years from the date of issuance.

(e) Investments

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

     The Company’s investment in MusicNet, Inc. (MusicNet) is accounted for under the equity method of accounting. Under the equity method of accounting, the Company’s share of the investee’s earnings or loss is included in the Company’s consolidated operating results. In certain cases where the Company has loaned the investee funds, the Company may record more than its relative equity share of the investee’s losses.

(f) Other Assets

     Other assets primarily consist of offering costs and other long-term deposits. The Company incurred the offering costs as a result of its convertible debt offering. These costs are deferred and are being amortized using the straight-line method, which approximates the effective interest method, over a 5-year period.

(g) Intangible Assets, net

     Intangible assets, net primarily consist of trade names, technology and patents that were acquired through certain of the Company’s acquisitions, as well as other purchased technology. The intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to five years. We evaluate the recoverability of intangible assets periodically and take into account events or circumstances that warrant revised estimates of useful lives or that may indicate that impairment exists. All of our intangible assets are subject to amortization. No impairments of intangible assets have been identified during any of the periods presented.

(h) Revenue Recognition

     The Company recognizes revenue in connection with its software products pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements” (SOP 98-9). Some of the Company’s software arrangements include consulting implementation services sold separately under consulting engagement contracts. If the consulting services are essential to the functionality of the software, or payment of the license fee depends on the performance of the services, both the software license and consulting fees are recognized under the percentage of completion method of contract accounting in accordance with Statement of Position 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1).

     For transactions not falling under the scope of SOP 97-2, the Company’s revenue recognition policies are in accordance with Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21) and Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin 104, “Revenue Recognition” (SAB 104).

     Revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. If at the outset of the customer arrangement, the Company determines that the arrangement

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fee is not fixed or determinable or that collectibility is not probable, the Company defers the revenue and recognizes the revenue when the arrangement fee becomes due and payable or as cash is received when collectibility concerns exist.

     For multiple element arrangements when Company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, the Company recognizes revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, the Company defers revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognizes the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. If Company-specific objective evidence does not exist for an undelivered element in a software arrangement, which may include distribution or other term-based arrangements in which the license fee includes support during the arrangement term, revenue is recognized over the term of the support period commencing upon delivery of the Company’s technology to the customer. For software license fees in single element arrangements such as consumer software sales and music copying or “burning,” revenue recognition typically occurs when the product is made available to the customer for download.

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

     Service revenue includes payments under support and upgrade contracts, media subscription services, and fees from consulting services and streaming media content hosting. Support and upgrade revenue is recognized ratably over the term of the contract, which typically is twelve months. Media subscription service revenue is recognized ratably over the period that services are provided, which is generally one to twelve months. Other service revenue is recognized when the services are performed. Service revenue also includes fees generated from advertising appearing on the Company’s Web sites and products. The Company may guarantee a minimum number of advertising impressions, click-throughs or other criteria on the Company’s Web sites or products for a specified period. To the extent these guarantees are not met, the Company defers recognition of the corresponding revenue until guaranteed delivery levels are achieved.

(i) Net Loss Per Share

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

     The share count used to compute basic and diluted net loss per share is calculated as follows (in thousands):

     Potential dilutive securities outstanding were not included in the computation of diluted net loss per common share, because to do so would have been anti-dilutive. Potential dilutive securities for the quarter and nine months ended September 30, 2004 included options to purchase approximately 36,805,000 common shares and approximately 10,750,000 contingently issuable common shares related to convertible debt as described in Note 7. Potential dilutive securities for the quarter and nine months ended September 30, 2003 included options to purchase approximately 36,865,000 common shares, warrants to acquire approximately 23,000 common shares and approximately 10,750,000 contingently issuable shares related to convertible debt.

(j) Derivative Financial Instruments

     During the nine months ended September 30, 2004, the Company entered into foreign currency forward contracts to manage the foreign currency risk of certain intercompany balances denominated in a foreign currency. Although these instruments are effective as a hedge from an economic perspective, they do not meet the criteria for hedge accounting under Statement of Financial Accounting

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Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), as amended.

     At September 30, 2004, the following foreign currency contracts were outstanding and recorded at fair value (in thousands):

     At December 31, 2003, the following foreign currency contracts were outstanding and recorded at fair value (in thousands):

     No derivative instruments designated as hedges for accounting purposes were outstanding at September 30, 2004 or December 31, 2003.

     (k) Comprehensive Income (Loss)

     The Company’s comprehensive income (loss) for the quarters and nine months ended September 30, 2004 and 2003 consisted of net loss, net unrealized gains on investments and the net amount of foreign currency translation adjustments. The tax effect of the foreign currency translation adjustments and unrealized gains and losses on investments has been taken into account if applicable. The components of accumulated other comprehensive income are as follows (in thousands):

(l) Stock-Based Compensation

     The Company has elected to apply the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) and Statement of Financial Accounting Standards No. 148, “Accounting for Stock Based Compensation, Transition and Disclosure” (SFAS 148). Accordingly, the Company accounts for stock-based compensation transactions with employees using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and related interpretations. Compensation cost for employee stock options is measured as the excess, if any, of the fair value of the Company’s common stock at the date of grant over the stock option exercise price. Compensation cost for awards to non-employees is based on the fair value of the awards in accordance with SFAS 123 and related interpretations.

     The Company recognizes compensation cost related to fixed employee awards on an accelerated basis over the applicable vesting period using the methodology described in Financial Accounting Standards Board (FASB) Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans” (FIN 28). At September 30, 2004, the Company has six stock-based employee compensation plans. The following table illustrates the effect on net loss and net loss per share if the Company

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had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):

(m) Recently Issued Accounting Standards

     In March 2004, the FASB’s Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (EITF 03-1). The guidance prescribes a three-step model for determining whether an investment is other-than-temporarily impaired and requires disclosures about unrealized losses on investments. The accounting guidance is effective for reporting periods beginning after June 15, 2004, while the disclosure requirements are effective for annual reporting periods ending after June 15, 2004. In September 2004, the FASB issued FASB Staff Position EITF 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1 ‘The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”’ (FSP EITF 03-1-1). FSP EITF 03-1-1 delays the effective date for the measurement and recognition guidance contained in paragraphs 10-20 of EITF Issue 03-1. During the period of the delay, FSP EITF 03-1-1 states that companies should continue to apply relevant “other-than-temporary” guidance. The adoption of EITF 03-1, excluding paragraphs 10-20, did not impact the Company’s consolidated financial statements. The Company will assess the impact of paragraphs 10-20 of EITF 03-1 once the guidance has been finalized.

     In June 2004, the Emerging Issues Task Force reached a consensus on Issue No. 02-14, “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock” (EITF 02-14). EITF 02-14 addresses whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means, how the equity method should be applied to investments other than common stock, and for securities with a readily determinable fair market value, how the provisions of Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (APB 18), and Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115), interact. The consensus in this EITF is effective for reporting periods beginning after September 15, 2004. The adoption of EITF 02-14 did not impact the Company’s consolidated financial statements.

In September 2004, the EITF reached a consensus on EITF Issue No. 04-8, “The Effect of Contingently Convertible Debt on Earnings Per Share” (EITF 04-8), which addresses when the diluted effect of contingently convertible debt instruments should be included in diluted earnings per share (EPS). EITF 04-8 requires that contingently convertible debt instruments are to be included in the computation of diluted EPS regardless of whether the market price trigger has been met. For comparative purposes, the adoption of EITF 04-8 will also require that previously reported diluted EPS amounts be restated to include the provisions of EITF 04-8. EITF 04-8 is expected to be effective for reporting periods ending after December 15, 2004. EITF 04-8 will not impact the Company’s diluted earnings per share calculations for prior periods through September 30, 2004, since the inclusion of the potential shares related to the Company’s contingently convertible debt would be anti-dilutive. The Company does not anticipate that EITF 04-8 will have a significant impact on future diluted earnings per share calculations.

(n) Reclassifications

     Certain reclassifications have been made to the September 30, 2003 consolidated financial statements to conform to the September 30, 2004 presentation.

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NOTE 2 — SEGMENT INFORMATION

     Prior to 2004, the Company operated in one business segment: media delivery. The Company began measuring its business by segments beginning in the quarter ended March 31, 2004, and now operates in two business segments: Consumer Products and Services and Business Products and Services, for which the Company receives revenue from its customers. Since the Company began measuring its business by segments beginning in the quarter ended March 31, 2004, comparable results of segment profit and loss for 2003 are not presented, as they are not available. The Company’s Chief Operating Decision Maker is considered to be the Company’s CEO Staff (CEOS), which is comprised of the Company’s Chief Executive Officer, Chief Financial Officer, Senior Vice Presidents, General Counsel, and the Company’s Chief Strategy Officer. The CEOS reviews financial information presented on both a consolidated basis and on a business segment basis, accompanied by disaggregated information about products and services and geographical regions for purposes of making decisions and assessing financial performance. The CEOS reviews discrete financial information regarding profitability of the Company’s Consumer Products and Services and Business Products and Services and, therefore, the Company reports these as operating segments as defined by Statement of Financial Accounting Standards No. 131, “Disclosure About Segments of an Enterprise and Related Information” (SFAS 131).

     The Company’s customers consist primarily of business customers and individual consumers located in the United States and various foreign countries. Revenue by geographic region is as follows (in thousands):

     The Company’s segment revenue is defined as follows:

•

Consumer Products and Services revenue is derived from sales of digital media subscription services, content such as games and music, the Company’s RealPlayer Plus and other related products, sales and distribution of third party software products and services, and advertising. These products and services are sold and provided primarily through the Internet, and the Company charges customers’ credit cards at the time of sale. Billing periods for subscription services typically occurs monthly, quarterly or annually, depending on the service purchased.

•

Business Products and Services revenue is derived from sales of media delivery system software, including RealServers and Helix system software for both wireline and wireless systems, related authoring and publishing tools, digital rights management technology, support and maintenance services, broadcast hosting services and consulting services. These products and services are primarily sold to corporate customers.

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     Net revenue by segment is as follows (in thousands):

     Consumer Products and Services revenue is comprised of the following (in thousands):

     Consumer Products and Services revenue is comprised of the following (in thousands):

     Long-lived assets, net by geographic region are as follows (in thousands):

     Goodwill, net is assigned to the Company’s segments as follows (in thousands):

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     Reconciliation of segment operating income (loss) to net loss before income taxes for the quarter and nine months ended September 30, 2004 is as follows (in thousands):

Operating expenses of both Consumer Products and Services and Business Products and Services include costs directly attributable to those segments and an allocation of general and administrative expenses and other corporate overhead costs. General and administrative and other corporate overhead costs are allocated to the segments and are generally based on the relative head count of each segment. The accounting policies used to derive segment results are generally the same as those described in Note 1.

The Company was able to identify historical information for segment cost of revenue and as a result presents net revenue and cost of revenue by segment for the quarter and nine months ended September 30, 2003 as follows (in thousands):

Since the Company began measuring its business by segments beginning in the quarter ended March 31, 2004, comparable results of segment profit and loss for 2003 are not presented, as they are not available.

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NOTE 3 — ACQUISITION

     On January 30, 2004, the Company acquired all of the outstanding securities of GameHouse, Inc. (GameHouse) in exchange for approximately $9.1 million in cash payments, including an estimated future payment of $0.1 million to cover certain tax obligations of the selling shareholders, and 3.0 million shares and options to acquire 0.3 million shares of RealNetworks common stock valued at approximately $20.9 million. The value assigned to the stock portion of the purchase price is $6.40 per share based on the average closing price of RealNetworks’ common stock for the five days beginning two days prior to and ending two days after January 26, 2004 (the date of the Agreement and Plan of Merger). Options issued were valued based on the Black-Scholes options pricing model. Included in the purchase price is $0.4 million in estimated acquisition-related expenditures consisting primarily of professional fees. Certain former GameHouse shareholders are eligible to receive up to $5.5 million over a four-year period, payable in cash or, at the Company’s discretion, in RealNetworks common stock valued in that amount provided they remain employed by RealNetworks during such period. In addition, the Company may be obligated to pay up to $1.0 million over a four-year period to certain GameHouse employees in the form of a management incentive plan. Such amounts are not included in the aggregate purchase price and, to the extent earned, will be recorded as compensation expense over the related employment periods.

     GameHouse is a developer, publisher and distributor of downloadable PC and mobile games. The Company believes that combining GameHouse’s assets with RealNetworks’ subscription games service and downloadable games distribution platform will strengthen the Company’s position in the PC games market. The results of GameHouse’s operations are included in RealNetworks’ consolidated financial statements starting from the date of acquisition.

     A summary of the purchase price for the acquisition is as follows (in thousands):

     The aggregate purchase consideration has been allocated to the assets and liabilities acquired, including identifiable intangible assets, based on their respective estimated fair values as summarized below. The respective estimated fair values were determined as of the acquisition date and resulted in excess purchase consideration over the net tangible and identifiable intangible assets acquired of $21.9 million.

     A summary of the allocation of the purchase price is as follows (in thousands):

     Technology/Games have a weighted average estimated useful life of two years. Tradename and customer list have a weighted average estimated useful life of four years.

NOTE 4 — OTHER INVESTMENTS

     RealNetworks has made minority equity investments for business and strategic purposes through the purchase of voting capital stock of certain companies. The Company’s investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term as they are strategic in nature. The Company periodically evaluates whether declines in fair value, if any, of its investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent of which the quoted market price is less than its accounting basis. The Company also considers other factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation

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also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, the Company considers similar qualitative and quantitative factors and also considers the implied value from any recent rounds of financing completed by the investee. During the quarter ended March 31, 2003, certain of the Company’s investments were written down to fair value based upon the Company’s analysis that the declines in fair value were other-than-temporary resulting in an impairment charge of $0.4 million. Based upon an evaluation of the facts and circumstances during the quarter ended September 30, 2004, the Company determined that there was an other-than-temporary decline in the fair value of a privately held minority investment resulting in an impairment charge of $0.5 million for the quarter then ended.

     As of September 30, 2004, the Company owned marketable equity securities of a Japanese company, representing approximately 14% of the investee’s outstanding shares, accounted for as available-for-sale securities. The market value of these shares has increased from the Company’s original cost of approximately $1.0 million, resulting in a carrying value at September 30, 2004 of $39.2 million. The increase over the Company’s cost basis, net of tax effects is $21.3 million and is reflected as a component of accumulated other comprehensive income. The market for this company’s shares is relatively limited, and the share price is volatile. Accordingly, there can be no assurance that a gain of this magnitude, or any gain, can be realized through the disposition of these shares.

NOTE 5 — INVESTMENT IN MUSICNET

     The Company’s investment in MusicNet, a joint venture with several media companies to create a platform for online music subscription services, is accounted for under the equity method of accounting. As a result, the Company records in its statement of operations its equity share of MusicNet’s net loss, which was $1.3 million for the quarter and $3.4 million for the nine months ended September 30, 2004 and $1.1 million and $4.3 million for the comparable periods of 2003. The Company owns preferred stock in MusicNet and also owns convertible notes that are convertible into shares of MusicNet preferred stock. During 2003, the Company and the other investors in MusicNet contributed additional capital to MusicNet to fund its business. The Company contributed $3.0 million and received additional convertible notes for this investment. The Company anticipates that MusicNet will continue to incur losses in the foreseeable future and will require additional funding. The Company is not obligated to provide additional funding. For purposes of calculating the Company’s equity in net loss of MusicNet for the quarter ended September 30, 2004, the convertible notes were treated on an “as if” converted basis due to the nature and terms of the convertible notes. As a result, the losses recorded by the Company for the quarter ended September 30, 2004 represent approximately 36.9% of MusicNet’s net loss. As of September 30, 2004, the Company’s ownership interest in outstanding shares of capital stock of MusicNet was approximately 25.5% and the carrying value for its investment was $3.1 million. The Company recognized approximately $0.2 million and $0.7 million of revenue during the quarter and the nine months ended September 30, 2004, and $0.3 million and $0.9 million for the quarter and nine months ended September 30, 2003, respectively, related to license and services agreements with MusicNet.

NOTE 6 — LOSS ON EXCESS OFFICE FACILITIES AND CONTENT AGREEMENT

     In October 2000, the Company entered into a 10-year lease agreement for additional office space located near its corporate headquarters in Seattle, Washington. Due to the subsequent decline in the market for office space in Seattle and the Company’s re-assessment of its facilities requirements, the Company has accrued for estimated future losses on excess office facilities. The Company’s estimates are based upon many factors including projections of sublease rates and the time period required to locate tenants. During 2003, the Company secured an additional tenant at a sublease rate lower than the rate used in previous loss estimates. As a result, the Company adjusted its estimates to reflect the lower lease rate and recorded additional losses of $7.1 million. The loss estimate includes $14.7 million of sublease income, of which $8.0 million is committed under current sublease contracts. The Company did not identify any factors which caused it to revise its estimates during the quarter and nine months ended September 30, 2004. The Company also recorded an accrual for estimated future losses on excess office facilities in its allocation of the Listen purchase price. The Company regularly evaluates the market for office space. If the market for such space declines further in future periods or if the Company is unable to sublease the space based on its current estimates, the Company may have to revise its estimates, which may result in additional losses on excess office facilities. Although the Company believes its estimates are reasonable, additional losses may result if actual experience differs from projections.

     During the quarter ended September 30, 2004, the Company leveraged a termination option in its existing lease for the Company’s headquarters building in order to renegotiate the lease. In addition, the Company ceased use of approximately 16,000 square feet of office space, which will be returned to the landlord in May 2005, in accordance with the amended lease agreement discussed in Note 10. The Company recorded a loss on excess office facilities of approximately $0.9 million related to the expensing of net leasehold improvements and rent for the period between October 1, 2004 and April 30, 2005 related to the excess space the Company vacated as of September 30, 2004.

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     During the quarter ended March 31, 2004, the Company cancelled a content licensing agreement with one of its content partners. Under the terms of the cancellation agreement, the Company gave up rights to use the content, and ceased using the content in any of its products or services as of March 31, 2004. The resulting expense of $4.9 million represents the estimated fair value of payments to be made in accordance with the terms of the cancellation agreement.

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

NOTE 7 — CONVERTIBLE DEBT

     During 2003, the Company issued $100 million aggregate principal amount of zero coupon convertible subordinated notes due July 1, 2010, pursuant to Rule 144A under the Securities Act of 1933, as amended. The notes are subordinated to any Company senior debt, and are also effectively subordinated in right of payment to all indebtedness and other liabilities of its subsidiaries. The notes are convertible into shares of the Company’s common stock based on an initial effective conversion price of approximately $9.30 per share if (1) the closing sale price of the Company’s common stock exceeds $10.23, subject to certain restrictions, (2) the notes are called for redemption, (3) the Company makes a significant distribution to its shareholders or becomes a party to a transaction that would result in a change in control, or (4) the trading price of the notes falls below 95% of the value of common stock that the notes are convertible into, subject to certain restrictions; one of which allows the Company, at its discretion, to issue cash or common stock or a combination thereof upon conversion. On or after July 1, 2008, the Company has the option to redeem all or a portion of the notes that have not been previously purchased, repurchased or converted, in exchange for cash at 100% of the principal amount of the notes. The purchasers may require the Company to purchase all or a portion of the notes in cash on July 1, 2008 at 100% of the principal amount of the notes. As a result of this issuance, the Company has received proceeds of $97.0 million, net of offering costs. The offering costs are included in other assets and are being amortized over a five-year period. Interest expense from the amortization of offering costs in the amount of $0.2 million and $0.5 million is recorded in interest income, net for the quarter and nine months ended September 30, 2004, respectively. Interest expense was approximately $0.2 million for both the quarter and nine months ended September 30, 2003. The net proceeds of the issuance are intended to be used for general corporate purposes, acquisitions, other strategic transactions including joint ventures, and other working capital requirements.

NOTE 8 — GUARANTEES

     In the ordinary course of business, the Company is not subject to potential obligations under guarantees that fall within the scope of FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others (“FIN 45”) an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB interpretation No. 34, except for standard indemnification and warranty provisions that are contained within many of the Company’s customer license and service agreements, and give rise only to the disclosure requirements prescribed by FIN 45.

     Indemnification and warranty provisions contained within the Company’s customer license and service agreements are generally consistent with those prevalent in the Company’s industry. The duration of the Company’s product warranties generally does not exceed 90 days following delivery of the Company’s products. The Company has not incurred significant obligations under customer indemnification or warranty provisions historically and does not expect to incur significant obligations in the future. Accordingly, the Company does not maintain accruals for potential customer indemnification or warranty-related obligations.

NOTE 9 — LITIGATION

     In March 2004, the Company filed suit against MLB Advanced Media, L.P. (MLBAM) in the U.S. District Court for the Western District of Washington, asserting a claim for breach of contract relating to an agreement between the Company and MLBAM, which requires MLBAM to provide certain streaming media content in the Company’s formats. The Company sought injunctive relief requiring MLBAM to perform its obligations under that agreement. The Company also sought monetary damages and reasonable attorneys fees. MLBAM filed counterclaims in the action alleging false advertising, trademark infringement and related allegations, all of which the Company denied. In August 2004, MLBAM moved to dismiss its counterclaims and moved the U.S. District Court to

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dismiss the Company’s claims on jurisdictional grounds. Prior to the court’s ruling on MLBAM’s motion, the Company filed suit against MLBAM in King County Superior Court in the State of Washington, asserting substantially the same claims and seeking the same relief as set forth in the federal court action. The parties reached a settlement in October 2004 and both cases were dismissed. The settlement resolved the litigation in a satisfactory way and did not have a material effect on the Company’s financial position or results of operations.

     In December 2003, the Company filed suit against Microsoft Corporation in the U.S. District Court for the Northern District of California, pursuant to U.S. and California antitrust laws. The Company alleged that Microsoft has illegally used its monopoly power to restrict competition, limit consumer choice and attempt to monopolize the field of digital media. Microsoft has filed an answer denying the claims and raising a variety of defenses. The Company believes it has a strong case and intends to vigorously pursue the litigation. If successful, the Company may be entitled to both monetary and injunctive relief from Microsoft. The Company expects that the litigation will carry on for several years before it can be resolved through trial.

     In September 2003, a lawsuit was filed against the Company in federal court in Marshall, Texas, alleging that the Company infringes certain patents relating to the transmittal of information recorded on information storage “means” from a central server to subscribers via a high data rate digital telecommunications network. The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover damages from the alleged infringement. The Company has answered the complaint and filed a counterclaim against plaintiff challenging the validity of its patents at issue and asserting inequitable conduct. The Company disputes plaintiff’s allegations in this action and intends to vigorously defend itself against these claims.

     In June 2003, a lawsuit was filed against the Company and Listen in federal district court for the Northern District of Illinois, alleging that certain features of the Company’s and Listen’s products and services willfully infringe certain patents relating to allowing users “to search for streaming media files, to create custom playlists, and to listen to the streaming media file sequentially and continuously.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble damages from the alleged infringement. The Company has filed its answer and a counterclaim against plaintiff challenging the validity of the patents at issue. The trial court has also granted the Company’s motion to transfer the action to the Northern District of California. The Company disputes plaintiff’s allegations in this action and intends to vigorously defend itself.

     In March 2003, William Cirignani filed a putative consumer class action against the Company in Washington state court, alleging causes of action based on the Washington Consumer Protection Act and unjust enrichment. The plaintiff alleges that consumers who attempted to download or purchase certain of the Company’s products and services were fraudulently and deceptively enrolled in, and prevented from canceling, the Company’s subscription services. The plaintiff seeks compensatory damages, equitable relief in the form of an order prohibiting the alleged false and deceptive practices, treble damages and other relief. The trial court has granted the Company’s motion to stay the action pending arbitration on an individual, non-class basis and the Court of Appeals and the Washington Supreme Court have rejected the plaintiff’s appeal. The Company disputes plaintiff’s allegations in this action and intends to vigorously defend itself against these claims.

     In July 2002, a lawsuit was filed against the Company in federal court in Boston, Massachusetts, alleging that the Company willfully infringes certain patents relating to “the downloading of data from a server computer to a client computer.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble damages from the alleged infringement. The Company has filed counterclaims against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as its recovery of damages for plaintiff’s infringement of a Company patent, and reasonable attorneys fees and costs. The Company disputes plaintiff’s allegations in this action and intends to vigorously defend itself.

     From time to time the Company is, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including employment claims, contract-related claims and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. These claims, including those described above, even if not meritorious, could force the Company to spend significant financial and managerial resources. The Company is not aware of any legal proceedings or claims that the Company believes will have, individually or taken together, a material adverse effect on the Company’s business, prospects, financial condition or results of operations. However, the Company may incur substantial expenses in defending against third party claims and certain pending claims are moving closer to trial. The Company expects that its potential costs of defending these claims may increase as the disputes move into the trial phase of the proceedings. In the event of a determination adverse to the Company, the Company may incur substantial monetary liability, and/or be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position and results of operations.

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NOTE 10 – SUBSEQUENT EVENT

     Effective October 1, 2004, the Company entered into a Lease Amendment amending the Lease dated January 21, 1998 between the Company and 2601 Elliott LLC, regarding the Company’s headquarters building. The Lease Amendment provides for a reduction in the amount of office space leased by the Company of between 16,355 and 21,470 rentable square feet. Additionally, the Lease Amendment reduces the Company’s future lease expense by approximately $14.5 million over the next 6.5 years and extends the lease term by approximately 3.5 years to September 30, 2014. The Company also has the option to extend the term of the lease for two consecutive periods of five years.

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

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

Overview

     RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading global provider of network-delivered digital media content and services. The Company also develops and markets software products and services that enable the creation, distribution and consumption of digital media, including audio and video. Consumers use our services and software to find, play, purchase and manage free and premium digital content, including music, video and games. Broadcasters, network operators, media companies and enterprises use our products and services to create and deliver digital media to PCs, mobile phones and consumer electronics devices.

     We have been a pioneer in the development of technology for the transmission of digital media over the Internet, and we have used this technology leadership to create a large base of consumers, network operators and content owners who use our products and services to create, send and receive both free and paid content. Our strategy is to continue to grow and leverage this base of users to drive the creation of a market for premium digital audio and video content online and generate profitable revenue from this market in two primary ways:

     (1) as a creator, packager and seller of software and digital content to consumers; and

     (2) as a supplier of the underlying technology and business-to-business services to content owners and network operators to create and distribute digital content.

     Over the last several years, our core business has evolved to address changing dynamics in our industry. We initially developed our business as a leading provider of software technology for the delivery and playback of digital media content over digital networks, and became a leader in that market. We have recently leveraged our technology business and large technology user base to define and develop new markets and businesses predicated on digital media technology. These new businesses principally involve paid digital media content. We have aggressively pursued development of these new businesses, through both internal initiatives and strategic acquisitions of businesses and technologies. As these new businesses have developed, the focus of our core business, including our promotional efforts, has shifted toward these markets and has resulted in significant increases in the number of subscribers to our service offerings and sales of digital media content. The shift in our focus and the increase in the number of subscribers and sales of digital media content is reflected in our results of operations in the following primary ways:

•

A significant increase in service revenue, including primarily consumer subscription services;

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A significant increase in revenue in our music and games businesses; and

•

A higher percentage of our total revenue relating to our consumer businesses.

     Despite the aggregate growth of our consumer businesses, our overall results have been substantially affected over the last several years by slower sales and usage of our Business Products and Services. The reduction in sales and usage of our Business Products and Services during this period has been caused primarily by Microsoft’s continuing practice of bundling its competing Windows Media Player and server software for free with its Windows NT operating system products, which we believe is an illegal practice, and also by general macroeconomic conditions. The macroeconomic conditions resulted in cutbacks in capital and information technology spending by our customers and potential customers in prior periods. Our Business Products and Service revenue tends to be comprised of a number of larger transactions, which typically have lengthy and variable sales cycles. Due to the length and variability of these sales cycles and the size of the transactions, our sequential quarterly revenue has fluctuated based on the timing of

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the consummation of sales. Additionally, companies within the wireless telecommunications industry have introduced mobile products and services more slowly than we had expected. We believe that some or all of these factors have resulted in reduced sales of our Business Products and Services, resulting in declines in related revenue.

     We manage our business, and correspondingly report revenue, based on our two operating segments: Consumer Products and Services and Business Products and Services.

•

Consumer Products and Services, which primarily include: revenue from digital media subscription services such as RealOne SuperPass, RadioPass, Rhapsody, GamePass and stand-alone and add-on subscriptions; revenue from sales and distribution of third party software and services; sales of content such as music and game downloads; revenue from sales of premium versions of our RealPlayer and related products; and advertising revenue.

•

Business Products and Services, which primarily include: sales of our media delivery system software, including Helix system software and related authoring and publishing tools, both directly to customers and indirectly through original equipment manufacturer (OEM) channels; revenue from support and maintenance services that we sell to customers who purchase our software products; revenue from broadcast hosting services; and revenue from consulting services we offer to our customers.

     In August 2003, we acquired all of the outstanding securities of Listen.com, Inc. (Listen). Listen had developed and operated an on-demand streamed music subscription service called the Rhapsody service, which is now operated and integrated as part of our music services. Rhapsody subscribers pay a monthly subscription fee and also have the ability to burn compact discs for which they are charged a per-track fee. The results of Listen’s operations are included in our unaudited condensed consolidated financial statements and related notes thereto since the date of acquisition and impact the comparability of the 2004 results when compared to 2003.

     In January 2004, we acquired all of the outstanding securities of GameHouse, Inc. (GameHouse). GameHouse is a developer, publisher and distributor of downloadable PC games. We believe the acquisition strengthened our position in the downloadable PC games market by combining the assets of GameHouse with our downloadable games distribution platform. The results of GameHouse’s operations are included in our unaudited condensed consolidated financial statements since the date of acquisition and impact the comparability of the 2004 results when compared to 2003.

Critical Accounting Policies and Estimates

     The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Our critical accounting policies and estimates are as follows:

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Revenue recognition;

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Estimating sales returns and the allowance for doubtful accounts;

•

Estimating losses on excess office facilities;

•

Determining whether declines in the fair value of investments are other-than-temporary and estimating fair market value of investments in privately held companies;

•

Valuation of goodwill; and

•

Valuation of deferred income tax assets.

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

     For software related products and services, we recognize revenue pursuant to the requirements of Statement of Position No. 97-2,

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“Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements” (SOP 98-9). Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. Some of our software arrangements include consulting implementation services sold separately under consulting engagement contracts. If the consulting services are essential to the functionality of the software, or payment of the license fee depends on the performance of the services, both the software license and consulting fees are recognized under the percentage of completion method of contract accounting.

     In addition, for transactions not falling under the scope of SOP 97-2, our revenue recognition policies are in accordance with EITF 00-21 and Securities and Exchange Commission (SEC) Staff Accounting Bulletin 104, “Revenue Recognition” (SAB 104).

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

     For software license fees in single element arrangements and multiple element arrangements that do not include customization or consulting services, delivery typically occurs when the product is made available to the customer for download. For service and advertising revenue, delivery typically occurs as the services are being performed.

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

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

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

     If Company-specific objective evidence does not exist for an undelivered element in a software arrangement, which may include distribution or other term-based arrangements in which the license fee includes support during the arrangement term, revenue is recognized over the term of the support period commencing upon delivery of our technology to the customer.

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

     Service revenue includes payments under support and upgrade contracts, RealOne and Rhapsody subscription services, consulting services and streaming media content hosting. Support and upgrade revenue is recognized ratably over the term of the contract, which typically is twelve months. Media subscription service revenue is recognized ratably over the period that services are provided. Fees

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generated from advertising are recognized as advertising is delivered over the term of the contract. Other service revenue is recognized as the services are performed.

     Sales Returns and the Allowance for Doubtful Accounts. We must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances. Similarly, we must make estimates of the uncollectibility of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. Significant judgments and estimates must be made and used in connection with establishing allowances for sales returns and the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we were to make different judgments or utilize different estimates.

     Accrued Loss On Excess Office Facilities. We have made significant estimates in determining the appropriate amount of accrued loss on excess office facilities. If we made different estimates, our loss on excess office facilities would be significantly different from that recorded, which could have a material impact on our operating results. We have revised our original estimate three times in the last two years, increasing the accrual for loss on excess office facilities each time. These first two revisions were the result of changes in the market for commercial real estate where we operate. The third revision, which took place in 2003, was the result of adding an additional tenant at a sublease rate lower than the rate used in previous estimates. If the market for such space declines further in future periods or if we are unable to sublease the space based on our current estimates, we may have to revise our estimates, which may result in additional losses on excess office facilities.

     Impairment of Investments. As part of the process of preparing our consolidated financial statements we periodically evaluate whether any declines in the fair value of our investments are other-than-temporary. Significant judgments and estimates must be made to assess whether an other-than-temporary decline in fair value of investments has occurred and to estimate the fair value of investments in privately held companies. See “Other Income (Expense), Net” in the following pages for a discussion of the factors we considered in evaluating whether declines in fair value of our investments were other-than-temporary and the factors we considered in estimating the fair value of investments in private companies.

     Valuation of Goodwill. We assess the impairment of goodwill on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:

•

poor economic performance relative to historical or projected future operating results;

•

significant negative industry, economic or company specific trends;

•

changes in the manner of our use of the assets or the plans for our business; and

•

loss of key personnel.

     If we were to determine that the fair value of a reporting unit was less than its carrying value, including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, we would measure impairment based on a comparison of the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference. Judgment is required in determining what our reporting units are for the purpose of assessing fair value compared to carrying value.

     Valuation of Deferred Income Tax Assets. In accordance with generally accepted accounting principles, we must periodically assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent that recovery is not likely, a valuation allowance must be established. The establishment of a valuation allowance and increases to such an allowance result in either increases to income tax expense or reduction of income tax benefits in the statement of operations. Factors we consider in making such an assessment include, but are not limited to, past performance and our expectation of future taxable income, macro-economic conditions and issues facing our industry, existing contracts, our ability to project future results and any appreciation of our investments and other assets. As of September 30, 2004 and December 31, 2003, we had established valuation allowances equal to our net deferred tax assets.

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Revenue by Segment

     We operate our business in two segments: Consumer Products and Services and Business Products and Services.

     Consumer Products and Services. Consumer Products and Services revenue is derived from sales of digital media subscription services, our RealPlayer Plus and other related products, sales and distribution of third party software products and services, sales of digital content such as games and music, and advertising. These products and services are sold primarily through the Internet, and the Company charges customers’ credit cards at the time of sale. Billing periods for subscription services typically occurs monthly, quarterly or annually, depending on the service purchased. Consumer Products and Services revenue increased in the quarter and nine months ended September 30, 2004 primarily due to: (1) growth in aggregate subscribers to our digital media subscription services and the related growth in revenue; (2) revenue related to new third party product distribution agreements; (3) revenue from our Rhapsody music service since the date of our acquisition of Listen, and subsequent growth in the number of Rhapsody subscribers; (4) revenue related to the online sale of individual songs through our Rhapsody music subscription service (which we began selling after we acquired Listen in August 2003) and through our new RealPlayer Music Store, which we launched in January 2004 and (5) revenue related to our GameHouse product offerings, which we acquired in January 2004. These increases were partially offset by decreases in sales of our premium consumer license products and third party consumer license products. We believe the growth in certain of our subscription services is due in part to the continued shift in our marketing and promotional efforts to these services as well as product improvements. While revenue related to our digital media subscription services has increased substantially on a year-over-year basis, the rate of growth has fluctuated on a quarterly basis. We cannot predict with accuracy how these subscription offerings will perform in the future, at what rate digital media subscription service revenue will grow, if at all, or the nature or potential impact of anticipated competition.

     Business Products and Services. Business Products and Services revenue is derived from the licensing of our media delivery system software, including Helix system software and related authoring and publishing tools, digital rights management technology, support and maintenance services that we sell to customers who purchase these products, broadcast hosting services we provide and consulting services we offer to our customers. These products and services are primarily sold to corporate, government and educational customers. We do not require collateral from our customers, but we often require payment before or at the time products and services are delivered. Many of our customers are given standard commercial credit terms, and for these customers we do not require payment before products and services are delivered. Business Products and Services revenue decreased in the quarter and nine months ended September 30, 2004 due primarily to decreases in revenue from certain of our business software products, including revenue from our OEM partners. In addition, in the nine months ended September 30, 2003, we recognized revenue related to a past contract with a customer who had filed for bankruptcy protection. The bankruptcy court relieved us of any future support or other obligations, and as a result, we recognized the remaining amount of deferred revenue in June 2003. The decrease in revenue was partially offset by an increase in sales of our system software to mobile and wireless infrastructure companies in the quarter and nine months ended September 30, 2004, as compared to the same periods in 2003. We believe the decreases in sales of certain of our business software products were substantially affected by Microsoft’s continuing practice of bundling its competing Windows Media Player and server software for free with its Windows NT operating system products, which we believe is an illegal practice. Our Business Products and Services revenue tends to be comprised of a number of larger transactions, which typically have lengthy and variable sales cycles. Due to the length and variability of these sales cycles and the size of the transactions, our sequential quarterly

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revenue has fluctuated based on the timing of the consummation of the related agreements. Additionally, companies within the wireless telecommunications industry have introduced mobile products and services more slowly than we had expected. No assurance can be given when, or if, we will experience increased sales of our business products and services to customers in these markets.

Consumer Products and Services Revenue

     A further analysis of our Consumer Products and Services revenue is as follows:

     Video, Consumer Software and Other. Video, consumer software and other revenue includes primarily revenue from our RealOne and stand-alone premium video subscription services, RealPlayer Plus and related products, revenue from support services that we sell to customers who purchase these products, and sales and distribution of third-party software products and all advertising other than that related directly to games and music. Revenue decreased in the quarter and nine month period ended September 30, 2004 primarily due to decreases in revenue in our RealOne Superpass subscription service and decreased sales of our premium consumer license products and third party consumer license products. These decreases were partially offset by increases in revenue related to new third party distribution agreements. The decrease in revenue from our RealOne Superpass subscriptions and premium consumer license products as well as the decrease in revenue related to third party consumer license products is due primarily to a shift in our marketing and promotional efforts towards our music and games subscription services, which we believe represent a greater growth opportunity for us.

     Music. Music revenue primarily includes revenue from our Rhapsody and RadioPass subscription services, sales of music content and advertising from our music Web sites. The increase in revenue during the quarter and nine months ended September 30, 2004 is due primarily to the inclusion and subsequent growth of the Rhapsody service (which we began selling after we acquired Listen in August 2003) and the growth of our RadioPass service that we introduced in the fourth quarter of 2002. We also launched additional international versions of RadioPass at the end of the first quarter of 2004, which contributed to the growth of our music revenue in the first nine months of 2004. Also, during the quarter ended March 31, 2004, we began offering online sales of individual songs through our new music store, which further contributed to revenue growth. We believe the growth during the third quarter of 2004 is due primarily to the broader acceptance of paid online music services and increased focus of our marketing efforts on our music offerings, including our promotion of our Harmony technology, which enables consumers to transfer secure digital music to a wide variety of portable music devices. As part of the promotion, we sold individual songs at a discounted price, which increased our overall Consumer Products and Services revenue and associated cost of sales and reduced our overall margins.

     Games. Games revenue primarily includes revenue from game downloads through our RealArcade service and our GameHouse Web site, revenue from our GamePass subscription service and related advertising. The increase in revenue during the quarter and nine months ended September 30, 2004 is due primarily to an increase in the number of subscribers and related revenue for our GamePass subscription service since its introduction in the fourth quarter of 2002 and revenue related to our GameHouse product offerings. Additionally, the growth in Games revenue is also due to the increased focus of our marketing efforts on our Games business and the addition of new game titles to our RealArcade and GamePass offerings.

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Geographic Revenue

     Revenue generated in the United States increased for the quarter and nine months ended September 30, 2004 primarily due to the growth of our Music and Games businesses and revenue from distribution of third party software and services. See the Games and Music sections above for further discussion of the changes.

     International revenue increased for the quarter and nine months ended September 30, 2004 primarily due to increased sales of our system software to mobile and wireless infrastructure companies, growth of our games business internationally, as well as the launch of our international RadioPass subscription service during 2004. International revenue decreased as a percentage of overall revenue from 27% to 24% for the quarter and from 28% to 24% for the nine months ended September 30, 2004 principally due to the strong growth of our overall U.S. consumer business, which resulted in our U.S. revenue growing at a faster rate than International revenue.

Revenue

     In accordance with SEC regulations, we also present our revenue based on License Fees and Service Revenue as set forth below.

     License Fees. License fees primarily include: sales of our media delivery system software, including Helix system software and related authoring and publishing tools, both directly to customers and indirectly through OEM channels; revenue from sales of premium versions of our RealPlayer Plus and related products; sales of third-party products and content such as game downloads and digital music. License fees include revenue from both our Consumer and Business Products and Services segments. The increase in license fees for the quarter and nine months ended September 30, 2004 was primarily due to an increase in incremental revenue related to the sale of games content related to GameHouse product offerings, revenue from the online sale of individual songs through our Rhapsody music subscription service (which we began selling after we acquired Listen in August 2003) and through our new RealPlayer Music Store, which we launched in January 2004, and increased sales of our system software to mobile and wireless infrastructure companies. These increases were offset by decreases in revenue from certain of our business software products, including revenue from our OEM partners and decreased sales of our premium consumer license products and third party consumer license products. See “Revenue by Segment – Consumer Products and Services” and “Revenue by Segment – Business Products and Services” above for further detailed explanation of changes.

     Service Revenue. Service revenue primarily includes: revenue from digital media subscription services such as RealOne SuperPass, RadioPass, Rhapsody, GamePass and stand-alone and add-on subscriptions; revenue from support and maintenance

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services that we sell to customers who purchase our software products; revenue from broadcast hosting services; revenue from consulting services we offer to our customers; and revenue from distribution of third party software and advertising revenue. Service revenue includes revenue from both our Consumer and Business Products and Services segments. The increase in service revenue during the quarter and nine months ended September 30, 2004 was primarily attributable to growth in aggregate subscribers to our digital media subscription services and an increase in revenue related to third-party product distribution agreements, partially offset by decreases in other service offerings including support and upgrades. Our subscription services accounted for approximately $37.7 million and $27.9 million of service revenue during the quarters ended September 30, 2004 and 2003, respectively. Our subscription services accounted for approximately $104.1 million and $77.0 million of service revenue during the nine months ended September 30, 2004 and 2003, respectively. The reasons for increases in subscription revenue are described in more detail in “Revenue by Segment — Consumer Products and Services” above. We believe the decreased revenue in our other service offerings, including support and upgrades, are due primarily to the factors described above in “Revenue by Segment — Business Products and Services.”

Deferred Revenue

     Deferred revenue is comprised of the unrecognized revenue related to support contracts, prepayments under OEM arrangements, unearned subscription services and other prepayments for which the earnings process has not been completed. Deferred revenue at September 30, 2004 was $32.8 million compared to $35.7 million at December 31, 2003. The decrease in deferred revenue during 2004 is primarily due to prepayments received under contracts occurring at a slower rate than recognition of revenue on existing contracts. The slower rate of prepayment receipts has been largely due to the decrease in new contracts in our Business Products and Services business segment in recent periods, which historically represented a significant portion of deferred revenue. We believe the decrease in new contracts in our Business Products and Services business segment results primarily from the conditions described in “Revenue by Segment – Business Products and Services” above. The decrease in prepayments under contracts was partially offset by an increase in deferred revenue from subscription services resulting from an increase in subscribers.

Cost of Revenue by Segment

     Cost of Consumer Products and Services. Cost of Consumer Products and Services revenue includes cost of content, and delivery of the content, included in our digital media subscription service offerings, royalties paid on sales of games, music and other third-party products, amounts paid for licensed technology, costs of product media, duplication, manuals, packaging materials, and fees paid to third-party vendors for order fulfillment and support services. Cost of Consumer Products and Services revenue increased by 35% and 59% for the quarter and nine months ended September 30, 2004, respectively. The increases were due to an increase in licensing costs associated with the online sale of individual songs, increased costs associated with delivering content to a greater number of subscribers, costs associated with the Rhapsody subscription service resulting from our acquisition of Listen and the amortization of intangible assets resulting from the acquisition of GameHouse. Additionally, the increase was due to our promotional activities related to our Harmony technology. The increase in costs for the nine-month period was also due to the Loss on Content Agreement, described below. Cost of Consumer Products and Services revenue decreased as a percentage of Consumer Products and Services revenue from 46% to 41% for the quarter ended September 30, 2004 primarily due to the application of fixed content costs for certain contracts against a higher revenue base, the renegotiation of certain content agreements and the discontinuation of certain content offerings. Cost of Consumer Products and Services revenue increased from 41% to 43% for the nine-months ended September 30, 2004 primarily due to the Loss on Content Agreement, described below, which was partially offset by the application of fixed content costs for certain contracts against a higher revenue base as well as the renegotiation of certain content agreements and the discontinuation of certain content offerings.

     Cost of Business Products and Services. Cost of Business Products and Services revenue includes amounts paid for licensed technology, costs of product media, duplication, manuals, packaging materials, fees paid to third-party vendors for order fulfillment, cost of in-house and contract personnel providing support and consulting services, and expenses incurred in providing our streaming media hosting services. Cost of Business Products and Services revenue for the quarter ended September 30, 2004 was consistent with the same period in 2003 and increased as a percentage of Business Products and Services revenue from 13% to 16%. Cost of Business Products and Services revenue for the nine months ended September 30, 2004 increased by 15% and increased as a

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percentage of Business Products and Services revenue from 12% to 16%. The increase during the quarter and nine months ended September 30, 2004 was primarily due to higher costs of revenue related to custom development work and a shift in mix towards products with higher product royalty costs.

Cost of Revenue

     Cost of License Fees. Cost of license fees includes royalties paid on sales of games, music and other third-party products, amounts paid for licensed technology, costs of product media, duplication, manuals, packaging materials, and fees paid to third-party vendors for order fulfillment. Cost of license fees for the quarter ended September 30, 2004 increased 189% and increased as a percentage of license fees revenue from 17% to 43%. Cost of license fees for the nine months ended September 30, 2004 increased 232% from the same period in 2003 and increased as a percentage of license fees from 13% to 39%. The increases were primarily due to increased licensing costs associated with the online sale of individual songs, including our promotional activities related to our Harmony technology and were also due to an increase in royalties resulting from a shift in product mix towards products with higher third party product royalties and the amortization of intangibles resulting from the acquisition of GameHouse.

     Cost of Service Revenue. Cost of service revenue includes the cost of content, and delivery of the content, included in our digital media subscription service offerings, cost of in-house and contract personnel providing support and consulting services, and expenses incurred in providing our streaming media hosting services. Cost of service revenue for the quarter ended September 30, 2004 increased 5% but decreased as a percentage of service revenue from 45% to 34%. Cost of service revenue for the nine months ended September 30, 2004 increased 15% but decreased as a percentage of service revenue from 41% to 34%. The increase in costs was primarily due to increased costs associated with delivering content to a greater number of subscribers and the costs of content included in our digital media subscription services. The content costs increased due to an increase in paying subscribers and the costs of adding new content to our services as well as an increase in costs associated with revenue from the Rhapsody service. The decrease in cost of service revenue as a percentage of service revenue was due to the application of fixed content costs for certain contracts against a higher revenue base, the renegotiation of certain content agreements and the discontinuation of certain content offerings.

     Our digital media subscription services, including Rhapsody, are a relatively new and growing portion of our business and, to date, have been characterized by higher costs of revenue than our other products and services, primarily due to the cost of licensing media content to provide these services. As a result, if our digital media subscription services continue to grow as a percentage of net revenue, our cost of service revenue may grow at an increased rate relative to net revenue, which will result in reductions in our gross margin percentages in the future. In addition, we anticipate that our cost of service revenue as a percentage of service revenue will fluctuate on a quarter-to-quarter basis due to seasonal characteristics of certain popular subscription content and as we periodically enter into new agreements for subscription content.

     Loss on Content Agreement. During the quarter ended March 31, 2004, we cancelled a content licensing agreement with PGA TOUR. Under the terms of the cancellation agreement, we gave up rights to use and ceased using PGA TOUR content in our products or services as of March 31, 2004. The expense represents the estimated fair value of payments to be made in accordance with the terms of the cancellation agreement.

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Operating Expenses

Research and Development