UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2002
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number 0-24363
Interplay Entertainment Corp.
(Exact name of the registrant as specified in its charter)
Delaware 33-0102707
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
16815 Von Karman Avenue, Irvine, California 92606
(Address of principal executive offices)
(949) 553-6655
(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 [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
Class Issued and Outstanding at Aug. 9, 2002
----- --------------------------------------
Common Stock, $0.001 par value 93,138,176
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
FORM 10-Q
JUNE 30, 2002
TABLE OF CONTENTS
-----------------
Page Number
-----------
Part I. Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of
June 30, 2002 (unaudited) and December 31, 2001......................3
Condensed Consolidated Statements of Operations
for the Three and Six Months ended June 30, 2002
and 2001 (unaudited).................................................4
Condensed Consolidated Statements of Cash Flows
for the Six Months ended June 30, 2002 and 2001
(unaudited)..........................................................5
Notes to Condensed Consolidated Financial Statements
(unaudited)..........................................................6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................................16
Item 3. Quantitative and Qualitative Disclosures About Market Risk..........35
Part II. Other Information
Item 1. Legal Proceedings...................................................36
Item 5. Other Information...................................................36
Item 6. Exhibits and Reports on Form 8-K....................................36
Signatures...................................................................38
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share amounts)
June 30, December 31,
2002 2001
ASSETS --------- ---------
Current Assets: (Unaudited)
Cash .......................................... $ 157 $ 119
Trade receivables from related parties,
net of allowances of $4,445 and
$4,025, respectively ...................... 7,063 6,175
Trade receivables, net of allowances
of $1,310 and $3,516, respectively ........ 1,814 3,312
Inventories ................................... 3,679 3,978
Prepaid licenses and royalties ................ 5,477 10,341
Note receivable from Infogrames ............... 5,682 --
Note receivable from Titus .................... 3,536 --
Other current assets .......................... 546 1,162
--------- ---------
Total current assets ...................... 27,954 25,087
Property and equipment, net ........................ 3,736 5,038
Other assets ....................................... -- 981
--------- ---------
$ 31,690 $ 31,106
========= =========
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current Liabilities:
Current debt .................................. $ -- $ 1,576
Accounts payable .............................. 13,438 13,718
Accrued royalties ............................. 3,165 7,795
Other accrued liabilities ..................... 3,166 2,999
Advances from distributors and others ......... 1,295 12,792
Advances from related parties ................. 5,338 10,060
Loans from related parties .................... -- 3,218
Payables to related parties ................... 10,179 7,098
Note payable .................................. 2,020 --
--------- ---------
Total current liabilities ................. 38,601 59,256
Commitments and contingencies (Notes 1, 5,
6 and 7)
Stockholders' Deficit:
Series A preferred stock, $.001 par
value, authorized 719,424 shares;
issued and outstanding zero and
383,354 shares, respectively .............. -- 11,753
Common stock, $.001 par value,
authorized 100,000,000 shares;
issued and outstanding 93,060,857
and 44,995,821 shares, respectively ....... 93 45
Paid-in capital ............................... 121,432 110,701
Accumulated deficit ........................... (128,577) (150,807)
Accumulated other comprehensive income ........ 141 158
--------- ---------
Total stockholders' deficit ............... (6,911) (28,150)
--------- ---------
$ 31,690 $ 31,106
========= =========
See accompanying notes.
3
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- --------------------
2002 2001 2002 2001
-------- -------- -------- --------
(In thousands, except per share amounts)
Net revenues ................... $ 1,812 $ 11,756 $ 11,193 $ 27,197
Net revenues from related party
distributors ............... 10,030 2,546 16,024 3,918
-------- -------- -------- --------
Total net revenues ......... 11,842 14,302 27,217 31,115
Cost of goods sold ............. 10,602 10,993 15,079 21,478
-------- -------- -------- --------
Gross profit ............... 1,240 3,309 12,138 9,637
Operating expenses:
Marketing and sales ........ 2,688 5,325 4,342 11,511
General and administrative . 1,819 4,097 4,835 6,583
Product development ........ 3,848 5,332 8,546 10,649
-------- -------- -------- --------
Total operating
expenses ............ 8,355 14,754 17,723 28,743
-------- -------- -------- --------
Operating income (loss) .... (7,115) (11,445) (5,585) (19,106)
Other income (expense):
Interest expense ........... (887) (707) (1,829) (1,366)
Gain on sale of Shiny ...... 28,781 -- 28,781 --
Other ...................... 14 (246) 921 (354)
-------- -------- -------- --------
Income (loss) before benefit
for income taxes ........... 20,793 (12,398) 22,288 (20,826)
Benefit for income taxes ....... 75 -- 75 --
-------- -------- -------- --------
Net income (loss) .............. $ 20,868 $(12,398) $ 22,363 $(20,826)
-------- -------- -------- --------
Cumulative dividend on
participating preferred
stock ...................... $ -- $ 300 $ 133 $ 600
Accretion of warrant ........... -- 67 -- 266
-------- -------- -------- --------
Net income (loss) available to
common stockholders ........ $ 20,868 $(12,765) $ 22,230 $(21,692)
======== ======== ======== ========
Net income (loss) per common
share:
Basic ...................... $ 0.22 $ (0.34) $ 0.30 $ (0.64)
======== ======== ======== ========
Diluted .................... $ 0.22 $ (0.34) $ 0.30 $ (0.64)
======== ======== ======== ========
Shares used in calculating net
income (loss) per common
share:
Basic ...................... 93,095 37,483 73,873 33,839
======== ======== ======== ========
Diluted .................... 93,095 37,483 73,873 33,839
======== ======== ======== ========
See accompanying notes.
4
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
June 30,
----------------------
2002 2001
-------- --------
Cash flows from operating activities: (In thousands)
Net income (loss) ............................... $ 22,363 $(20,826)
Adjustments to reconcile net income
(loss) to cash (used in) provided
by operating activities:
Depreciation and amortization ................ 880 1,330
Noncash expense for stock options ............ 33 --
Non-cash interest expense .................... 1,544 67
Write-off of prepaid royalties and licenses .. 2,100 2,251
Gain on sale of Shiny ........................ (28,781) --
Other ........................................ (53) (46)
Changes in assets and liabilities:
Trade receivables, net .................... 1,495 (1,284)
Trade receivables from related
parties ................................... (888) 17,590
Inventories ............................... 299 1,001
Prepaid licenses and royalties ............ 1,119 (1,301)
Other current assets ...................... 603 (81)
Accounts payable .......................... (1,326) 3,960
Accrued royalties ......................... (4,497) (1,883)
Other accrued liabilities ................. 321 27
Payables to related parties ............... 1,852 (4,440)
Advances from distributors and others ..... (19,719) 6,895
-------- --------
Net cash (used in) provided
by operating activities ................ (22,655) 3,260
-------- --------
Cash flows from investing activities:
Purchase of property and equipment .............. (22) (1,080)
Proceeds from sale of Shiny ..................... 27,420 --
-------- --------
Net cash provided by (used
in) investing activities ............... 27,398 (1,080)
-------- --------
Cash flows from financing activities:
Net (payment) borrowings of line of credit ...... (1,576) 6,064
Net payment of previous line of credit .......... -- (24,433)
Net payment of supplemental line of credit ...... -- (1,000)
(Repayment) borrowings from former Chairman ..... (3,218) 3,000
Net proceeds from issuance of common stock ...... 3 11,872
Proceeds from exercise of stock options ......... 86 9
Other ........................................... -- 150
-------- --------
Net cash used in financing
activities ............................. (4,705) (4,338)
-------- --------
Net increase (decrease) in cash .............. 38 (2,158)
Cash, beginning of period .......................... 119 2,835
-------- --------
Cash, end of period ................................ $ 157 $ 677
======== ========
Supplemental cash flow information:
Cash paid for:
Interest ............................... $ 278 $ 1,305
See accompanying notes.
5
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
JUNE 30, 2002
Note 1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of
Interplay Entertainment Corp. and its subsidiaries (the "Company") reflect all
adjustments (consisting only of normal recurring adjustments) that, in the
opinion of management, are necessary for a fair presentation of the results for
the interim period in accordance with instructions for Form 10-Q and Rule 10-01
of Regulation S-X. Accordingly, they do not include all information and
footnotes required by generally accepted accounting principles in the United
States for complete financial statements. The results of operations for the
current interim period are not necessarily indicative of results to be expected
for the current year or any other period. The balance sheet at December 31, 2001
has been derived from the audited consolidated financial statements at that
date, but does not include all information and footnotes required by generally
accepted accounting principles in the United States for complete financial
statements.
These consolidated financial statements should be read in conjunction with
the consolidated financial statements and notes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2001 as
filed with the Securities and Exchange Commission.
Factors Affecting Future Performance and Going Concern
The Company has incurred substantial operating losses and at June 30, 2002,
had a stockholders' deficit of $6.9 million and a working capital deficit of
$10.6 million. The Company has historically funded its operations primarily from
operations, through the use of lines of credit, royalty and distribution fee
advances, cash generated by the private sale of securities, and proceeds of its
initial public offering.
To reduce its working capital needs, the Company has implemented various
measures including a reduction of personnel, a reduction of fixed overhead
commitments, cancellation or suspension of development on future titles, which
management believes do not meet sufficient projected profit margins, and the
scaling back of certain marketing programs. Management will continue to pursue
various alternatives to improve future operating results, and further expense
reductions, some of which may have a long-term adverse impact on the Company's
ability to generate successful future business activities.
In addition, the Company continues to seek and expects to require external
sources of funding, including but not limited to, a sale or merger of the
Company, a private placement of the Company's capital stock, the sale of
selected assets, the licensing of certain product rights in selected
territories, selected distribution agreements, and/or other strategic
transactions sufficient to provide short-term funding, and potentially achieve
the Company's long-term strategic objectives. In this regard, the Company
completed the sale of its subsidiary Shiny Entertainment, Inc. ("Shiny") in
April 2002, for approximately $47.2 million (Note 2). The Company used the
proceeds from the sale of Shiny to fund operations and to pay existing
obligations, including $11.5 million of prepaid advances that were accelerated
as a condition of the transaction. Additionally, in August 2002, the Company's
Board of Directors has approved and commenced the process of establishing a
Special Committee comprised of directors that are independent of the Company's
largest stockholder, Titus Interactive S.A., to investigate strategic options,
including raising capital from the sale of debt or equity securities and a sale
of the Company.
The Company also entered into a new three year distribution agreement with
Vivendi Universal Games, Inc. ("Vivendi"). Under the new arrangement, cash
collections by the Company are accelerated.
If the Company's existing cash and operating revenues from future product
releases are not sufficient to fund the Company's operations, no assurance can
be given that alternative sources of funding could be obtained on acceptable
terms, or at all. These conditions, combined with the Company's historical
operating losses and its deficits in stockholders' equity and working capital,
raise substantial doubt about the Company's ability to continue as a going
concern. The accompanying consolidated financial statements do not include any
adjustments to reflect the possible future effects on the recoverability and
classification of assets and liabilities that may result from the outcome of
this uncertainty.
6
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Significant estimates made in preparing the consolidated financial statements
include sales returns and allowances, cash flows used to evaluate the
recoverability of prepaid licenses and royalties and long-lived assets, and
certain accrued liabilities related to restructuring activities and litigation.
Reclassifications
Certain reclassifications have been made to the prior period's financial
statements to conform to classifications used in the current period.
Prepaid Licenses and Royalties
Prepaid licenses and royalties consist of license fees paid to intellectual
property rights holders for use of their trademarks or copyrights. Also included
in prepaid royalties are prepayments made to independent software developers
under development arrangements that have alternative future uses. These payments
are contingent upon the successful completion of milestones, which generally
represent specific deliverables. Royalty advances are recoupable against future
sales based upon the contractual royalty rate. The Company amortizes the cost of
licenses, prepaid royalties and other outside production costs to cost of goods
sold over six months commencing with the initial shipment in each region of the
related title. The Company amortizes these amounts at a rate based upon the
actual number of units shipped with a minimum amortization of 75 percent in the
first month of release and a minimum of 5 percent for each of the next five
months after release. This minimum amortization rate reflects the Company's
typical product life cycle. Management evaluates the future realization of such
costs quarterly and charges to cost of goods sold any amounts that management
deems unlikely to be fully realized through future sales. Such costs are
classified as current and noncurrent assets based upon estimated product release
date.
Software Development Costs
Research and development costs, which consist primarily of software
development costs, are expensed as incurred. Statement of Financial Accounting
Standards ("SFAS") No. 86, "Accounting for the Cost of Computer Software to be
Sold, Leased, or Otherwise Marketed", provides for the capitalization of certain
software development costs incurred after technological feasibility of the
software is established or for development costs that have alternative future
uses. Under the Company's current practice of developing new products, the
technological feasibility of the underlying software is not established until
substantially all product development is complete, which generally includes the
development of a working model. The Company has not capitalized any software
development costs on internal development projects, as the eligible costs were
determined to be insignificant.
Accrued Royalties
Accrued royalties consist of amounts due to outside developers and
licensors based on contractual royalty rates for sales of shipped titles. The
Company records a royalty expense based upon a contractual royalty rate after it
has fully recouped the royalty advances paid to the outside developer, if any,
prior to shipping a title.
Revenue Recognition
Revenues are recorded when products are delivered to customers in
accordance with Statement of Position ("SOP") 97-2, "Software Revenue
Recognition" and SEC Staff Accounting Bulletin No. 101, Revenue Recognition.
With the signing of the Vivendi distribution agreement in August 2001,
substantially all of the Company's sales are made by two related party
distributors (Notes 5 and 10) as Vivendi owns approximately 5 percent of the
outstanding shares of the Company's common stock. The Company recognizes revenue
from sales by distributors, net of sales
7
commissions, only as the distributor recognizes sales of the Company's products
to unaffiliated third parties. For those agreements that provide the customers
the right to multiple copies of a product in exchange for guaranteed amounts,
revenue is recognized at the delivery of the product master or the first copy.
Per copy royalties on sales that exceed the guarantee are recognized as earned.
Guaranteed minimum royalties on sales that do not meet the guarantee are
recognized as the minimum payments come due. The Company is generally not
contractually obligated to accept returns, except for defective, shelf-worn and
damaged products in accordance with negotiated terms. However, on a case by case
negotiated basis, the Company permits customers to return or exchange product
and may provide markdown allowances on products unsold by a customer. In
accordance with Statement of Financial Accounting Standards ("SFAS") No. 48,
"Revenue Recognition when Right of Return Exists", revenue is recorded net of an
allowance for estimated returns, exchanges, markdowns, price concessions and
warranty costs. Such reserves are based upon management's evaluation of
historical experience, current industry trends and estimated costs. The amount
of reserves ultimately required could differ materially in the near term from
the amounts included in the accompanying condensed consolidated financial
statements. Customer support provided by the Company is limited to telephone and
Internet support. These costs are not material and are charged to expenses as
incurred. The Company also expects to engage in the sale of licensing rights on
certain products. The terms of the licensing rights differ, but normally include
the right to develop and distribute a product on a specific video game platform.
Revenue is recognized when the rights have been transferred and no other
obligations exist.
Recent Accounting Pronouncements
In April 2001, the Emerging Issues Task Force reached a consensus on Issue
No. 00-25 ("EITF 00-25"), "Accounting for Consideration from a Vendor to a
Retailer in Connection with the Purchase or Promotion of the Vendor's Products",
which states that consideration from a vendor to a reseller of the vendor's
products is presumed to be a reduction of the selling prices of the vendor's
products and, therefore, should be characterized as a reduction of revenue when
recognized in the vendor's income statement. That presumption is overcome and
the consideration can be categorized as a cost incurred if, and to the extent
that, a benefit is or will be received from the recipient of the consideration.
That benefit must meet certain conditions described in EITF 00-25. The Company
adopted the provisions of EITF 00-25 on January 1, 2002 and as a result net
revenues and marketing expenses were reduced by $0.5 million and $1.0 million
for the three and six months ended June 30, 2001, respectively. The adoption of
EITF 00-25 did not impact the Company's net loss for the three and six months
ended June 30, 2001.
In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other
Intangible Assets" effective for fiscal years beginning after December 15, 2001.
Under the new rules all acquisition transactions entered into after June 30,
2001, must be accounted for on the purchase method and goodwill will no longer
be amortized but will be subject to annual impairment tests in accordance with
SFAS 142. Other intangible assets will continue to be amortized over their
useful lives. The Company adopted the new rules on accounting for goodwill and
other intangible assets on January 1, 2002. The adoption of SFAS No. 142 did not
have a material impact on the Company's consolidated financial position or
results of operations. Goodwill amortization for the three and six months ended
June 30, 2001 was zero and $96,000, respectively. With the sale of Shiny, the
Company no longer has any recorded goodwill assets.
In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." SFAS No. 143 addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. The provisions of SFAS No. 143
are effective for financial statements issued for fiscal years beginning after
June 15, 2002, with early application encouraged and generally are to be applied
prospectively. The Company does not expect the adoption of SFAS No. 143 to have
a material impact on its consolidated financial position or results of
operations.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and the
accounting and reporting provisions of APB Opinion No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," for the disposal of a segment of a
8
business (as previously defined in that Opinion). The Company adopted the
provisions of SFAS No. 144 on January 1, 2002. The adoption of SFAS No. 144 did
not have a material impact on the Company's consolidated financial position or
results of operations.
Note 2. Sale of Shiny Entertainment, Inc
On April 30, 2002, the Company consummated the sale of Shiny, pursuant to
the terms of a Stock Purchase Agreement, dated April 23, 2002, as amended, among
the Company, Infogrames, Shiny, Shiny's president and Shiny Group, Inc. Pursuant
to the purchase agreement, Infogrames acquired all of the outstanding common
stock of Shiny for approximately $47.2 million, which was paid to or for the
benefit of the Company as follows:
o $3.0 million in cash paid to the Company at closing;
o $10.8 million to be paid to the Company pursuant to a promissory note
from Infogrames providing for scheduled payments with the final
payment due July 31, 2002;
o $26.1 million paid directly to third party creditors of the Company;
and
o $7.3 million paid to Shiny's president and Shiny Group for Shiny
common stock that was issued to such parties to settle claims relating
to the Company's original acquisition of Shiny.
As of August 1, 2002, the promissory note receivable from Infogrames was
fully paid.
The Company recognized a gain of $28.8 million on the sale of Shiny. The
details of the sale are as follows:
(In millions)
Sale price of Shiny $ 47.2
Net assets of Shiny at April 30, 2002 2.3
Transaction related costs:
Cash payment to Warner Brothers for consent
to transfer Matrix license 2.2
Note payable issued to Warner Brothers for
consent to transfer Matrix license 2.0
Payment to Shiny's President & Shiny Group 7.1
Commission fees to Europlay I, LLC 3.9
Legal fees 0.9
--------
Gain on sale $ 28.8
========
In addition, the Company recorded a tax provision of $150,000 in connection
with the sale of Shiny.
Concurrently with the closing of the sale, the Company settled a legal
dispute with Vivendi, relating to the parties' distribution agreement. The
Company also settled legal disputes with its former bank and its former
Chairman, relating to the Company's April 2001 credit facility with its former
bank that was partially guaranteed by its former Chairman. The disputes with
Vivendi, the bank and the former Chairman were settled and dismissed, with
prejudice, following consummation of the sale.
The Company issued to Warner Bros., a division of Time Warner Entertainment
Company, L.P., a Secured Convertible Promissory Note bearing interest at 6
percent per annum, due April 30, 2003, in the principal amount of $2.0 million.
The note was issued in partial payment of amounts due Warner Bros. under the
parties' license agreement for the video game based on the motion picture The
Matrix, which is being developed by Shiny. The note is secured by all of the
Company's assets, and may be converted by the holder thereof into shares of the
Company's common stock on the maturity date or, to the extent there is any
proposed prepayment, within the 30 day period prior to such prepayment. The
conversion price is equal to the lower of (a) $0.304 and (b) an amount equal to
the average closing price of a share of the Company's common stock for the five
business days ending on the day prior to the conversion date, provided that in
no event can the note be converted into more than 18,600,000 shares. If any
amount remains due following conversion of the note into 18,600,000 shares, the
remaining amount will be payable
9
in cash. The Company agreed to register with the Securities and Exchange
Commission the shares of common stock to be issued in the event Warner Bros.
Exercises its conversion option.
Note 3. Inventories
Inventories consist of the following:
June 30, December 31,
2002 2001
---------- ----------
(Dollars in thousands)
Packaged software $ 3,205 $ 3,230
CD-ROMs, cartridges, manuals, packaging and
supplies 474 748
---------- ----------
$ 3,679 $ 3,978
========== ==========
Note 4. Prepaid licenses and royalties
Prepaid licenses and royalties consist of the following:
June 30, December 31,
2002 2001
---------- ----------
(Dollars in thousands)
Prepaid royalties for titles in development $ 4,453 $ 7,539
Prepaid royalties for shipped titles, net of
amortization 551 710
Prepaid licenses and trademarks, net of
amortization 473 2,092
---------- ----------
$ 5,477 $ 10,341
========== ==========
Amortization of prepaid licenses and royalties is included in cost of goods
sold and totaled $4.5 million and $3.6 million for the three months ended June
30, 2002 and 2001, respectively and $5.6 million and $6.3 million for the six
months ended June 30, 2002 and 2001, respectively. Included in the amortization
of prepaid licenses and royalties are write-offs of development projects that
were cancelled because they were not expected to meet the Company's desired
profit requirements. These amounts totaled $2.1 million and $1.5 million for the
three months ended June 30, 2002 and 2001, respectively and totaled $2.1 million
and $2.3 million for the six months ended June 30, 2002 and 2001, respectively.
In addition, $1.6 million of prepaid royalties for the Matrix license was
included in the net assets of Shiny, which were sold to Infogrames (Note 2).
Note 5. Advances from Distributors and Others
Advances from distributors and OEMs consist of the following:
June 30, December 31,
2002 2001
------- -------
(Dollars in thousands)
Advance from console hardware manufacturer ....... $ -- $ 5,000
Advances for distribution rights to a future title -- 4,000
Advances for other distribution rights ........... 1,295 3,792
------- -------
$ 1,295 $12,792
======= =======
Sale of intellectual property rights to Titus .... $ 3,500 $ --
Net advance from Vivendi distribution agreement .. 1,838 10,060
------- -------
$ 5,338 $10,060
======= =======
In March 2001, the Company entered into a supplement to a licensing
agreement with a console hardware and software manufacturer under which it
received an advance of $5.0 million. This advance was repaid with proceeds from
the sale of Shiny.
10
In July 2001, the Company entered into a distribution agreement with a
distributor whereby the distributor would have the North American distribution
rights to a future title. In return, the distributor paid the Company an advance
of $4.0 million to be recouped against future amounts due to the Company based
on net sales of the future title. In January 2002, the Company sold the
publishing rights to this title to the distributor in connection with a
settlement agreement entered into with the third party developer. The settlement
agreement provided, among other things, that the Company assign its rights and
obligations under the product agreement to the third party distributor. In
consideration for assigning the product agreement to the distributor, the
Company was not required to repay the $4.0 million advance nor repay $1.6
million related to past royalties and interest owed to the distributor. In
addition, the Company agreed to forgive $0.6 million in advances previously paid
to the developer. As a result, the Company recorded net revenues of $5.6 million
and a related cost of sales of $0.6 million in the six months ended June 30,
2002.
Other advances from distributors are repayable as products covered by those
agreements are sold.
In April 2002, the Company entered into an agreement with Titus, pursuant
to which, among other things, the Company sold to Titus all right, title and
interest in the games "EarthWorm Jim", "Messiah", "Wild 9", "R/C Stunt Copter",
"Sacrifice", "MDK", "MDK II", and "Kingpin", and Titus licensed from the Company
the right to develop, publish, manufacture and distribute the games "Hunter I",
"Hunter II", "Icewind Dale I", "Icewind Dale II", and "BG: Dark Alliance II"
solely on the Nintendo Advance GameBoy game system for the life of the games. As
consideration for these rights, Titus issued to the Company a promissory note in
the principal amount of $3.5 million, which note bears interest at 6 percent per
annum. The promissory note is due on August 31, 2002, and may be paid, at Titus'
option, in cash or in shares of Titus common stock with a per share value equal
to 90 percent of the average trading price of Titus' common stock over the 5
days immediately preceding the payment date. The Company has provided Titus with
a guarantee under this agreement, which provides that in the event Titus does
not achieve gross sales of at least $3.5 million by June 25, 2003, and the
shortfall is not the result of Titus' failure to use best commercial efforts,
the Company will pay to Titus the difference between $3.5 million and the actual
gross sales achieved by Titus, not to exceed $2.0 million. The Company currently
maintains a $3.5 million note receivable from Titus included in trade accounts
receivable from related parties as well as a $3.5 million amount reflected as an
advance from Titus in the accompanying condensed consolidated financial
statements as of June 30, 2002.
In August 2001, the Company entered into a distribution agreement with
Vivendi providing for Vivendi to become the Company's distributor in North
America through December 31, 2003 for substantially all of its products, with
the exception of products with pre-existing distribution agreements. Under the
terms of the agreement, as amended, Vivendi earns a distribution fee based on
the net sales of the titles distributed. The agreement provided for three
advance payments from Vivendi totaling $10.0 million. In amendments to the
agreement, Vivendi agreed to advance the Company an additional $3.5 million. The
distribution agreement, as amended, provides for the acceleration of the
recoupment of the advances made to the Company, as defined. During the three
months ended March 31, 2002, Vivendi advanced the Company an additional $3.0
million bringing the total amounts advanced to the Company under the
distribution agreement with Vivendi to $16.5 million. In April 2002, the
distribution agreement was further amended whereby Vivendi will distribute
substantially all of the Company's products through December 31, 2002, except
certain future products, which Vivendi will have the distribution rights for one
year from the date of release. As of June 30, 2002, Vivendi has recouped $8.2
million in connection with the sale of Company products under the North American
distribution agreement and an additional $6.5 million was repaid to Vivendi in
connection with the Company's sale of Shiny. As of August 1, 2002, all remaining
distribution advances from Vivendi were fully recouped.
In August 2002, the Company entered into a new distribution arrangement
with Vivendi whereby Vivendi will distribute substantially all of the Company
products in North America. Under the Agreement, Vivendi will pay the Company
sales proceeds less amounts for distribution fees, price concessions and
returns, inventory and marketing costs. Upon the Company's delivery of a gold
master to Vivendi, Vivendi will pay the Company as a minimum guarantee, 75
percent of the projected amount due the Company based on projected initial
shipment sales, established by Vivendi in accordance with the terms of the
agreement, and the remaining amounts shall be due upon shipment of the titles to
Vivendi's customers. Any future sales exceeding the projected initial shipment
sales will be paid on a monthly basis. The new agreement with Vivendi has a term
of three years.
11
In the event the Company does not perform its obligations under any of the
agreements noted above, it would be obligated to refund any advances not
recouped against future sales.
Note 6. Commitments and Contingencies
The Company is involved in various legal proceedings, claims and litigation
arising in the ordinary course of business, including disputes arising over the
ownership of intellectual property rights and collection matters. In the opinion
of management, the outcome of known routine claims will not have a material
adverse effect on the Company's business, financial condition, results of
operations or cash flows.
On January 15, 2002, Rage Games Limited ("Rage") filed a breach of contract
action against the Company relating to the August 3, 2000 North American
distribution agreement and the February 9, 2001 OEM distribution agreement. In
the complaint, Rage alleged that the Company failed to make royalty payments
under these agreements. Rage sought damages in the amount of $2.9 million plus
interest and punitive damages. Furthermore, Rage sought to audit the Company's
books, return all of Rage's software and a cease and desist of all manufacturing
and further distribution of Rage's software. The Company settled its dispute
with Rage in April 2002 for $1.3 million to be paid in periodic installments. If
the Company does not make the payments in accordance with the terms of the
settlement, then Rage may execute on a stipulated judgment for the full amount
of the original claim.
On May 16, 2002, the listing of the Company's common stock was moved from
the Nasdaq National Market System to the Nasdaq SmallCap Market System. The
Company had until August 13, 2002 to comply with the requirements of the
SmallCap market, which include among other things, a stockholders' equity
balance of $5.0 million and a minimum bid price of $1.00. The Company currently
does not comply with the listing requirements of the Nasdaq SmallCap Market.
Nasdaq notified the Company on August 14, 2002 that its securities will be
delisted from the Nasdaq SmallCap Market at the opening of business on August
22, 2002 unless the Company appeals the staff's determination. The Company has
requested a hearing before a Nasdaq Listing Qualifications Panel to review the
Staff's determination. The hearing request will stay the delisting of the
Company's securities pending the Panel's decision. The Company's board of
directors' recently approved a 10 for 1 reverse stock split that will be voted
on at the annual stockholders' meeting on September 17, 2002. The Company will
continue to seek methods to meet the minimum equity requirement through a
combination of net income and recapitalization.
In June 2002, the Internal Revenue Service ("the IRS") concluded its
examination of the Company's consolidated federal income tax returns for the
years ended April 30, 1992 through 1997. In Fiscal 2001, the Company established
a reserve of $500,000, representing management's best estimate of amounts to be
paid in settlement of the IRS claims. In the second quarter of 2002, the Company
reached a settlement with the IRS and agreed to pay $275,000 to settle all
outstanding issues. With the executed settlement, the Company has adjusted its
reserve and, as a result, recorded an income tax benefit of $225,000.
Note 7. Stockholders' Equity
In March 2002, Titus converted its remaining 383,354 shares of Series A
Preferred Stock into 47,492,162 shares of common stock. This conversion did not
include accumulated dividends of $1.2 million on the preferred stock, which
Titus has elected to receive in cash. In July 2002, the Company paid Titus $1.0
million of the dividend payable. Subsequent to this conversion, Titus now owns
66,988,723 shares of the Company's common stock and had 72 percent of the total
voting power of the Company's capital stock as of June 30, 2002.
In April 2001, the Company completed a private placement of 8,126,770
shares of its common stock. The transaction provided for registration rights
with a registration statement to be filed by April 16, 2001 and an effective
date no later than May 31, 2001. The registration statement was not declared
effective by May 31, 2001 and in accordance with the terms of the agreement, the
Company incurred a penalty of approximately $254,000 per month, payable in cash,
until June 2002, when the registration statement was finally declared effective.
During the three and six months ended June 30, 2002, the Company recorded these
penalties as interest expense of $0.8 million and $1.6 million, respectively and
at June 30, 2002 had accrued penalties of $3.3 million, payable to these
stockholders. The
12
Company is currently involved in negotiations with the related private placement
investors to settle the payment obligations of the penalties.
Note 8. Net Earnings (Loss) Per Share
Basic earnings (loss) per share is computed as net earnings (loss)
attributable to common stockholders divided by the weighted-average number of
common shares outstanding for the period and does not include the impact of any
potentially dilutive securities. Diluted earnings per share is computed by
dividing the net earnings attributable to the common stockholders by the
weighted average number of common shares outstanding plus the effect of any
dilutive stock options and common stock warrants.
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------- --------------------------
2002 2001 2002 2001
------------ ------------ ------------ ------------
(In thousands, except per share amounts)
Net income (loss) available
to common stockholders ... $ 20,868 $ (12,765) $ 22,230 $ (21,692)
------------ ------------ ------------ ------------
Shares used to compute net
income (loss) per share:
Weighted-average common
shares ................ 93,095 37,483 73,873 33,839
Dilutive stock equivalents -- -- -- --
------------ ------------ ------------ ------------
Dilutive potential common
shares ................ 93,095 37,483 73,873 33,839
============ ============ ============ ============
Net income (loss) per share:
Basic .................... $ 0.22 $ (0.34) $ 0.30 $ (0.64)
Diluted .................. $ 0.22 $ (0.34) $ 0.30 $ (0.64)
There were options and warrants outstanding to purchase 11,268,933 shares
of common stock at June 30, 2002, which were excluded from the earnings per
share computation as the exercise price was greater than the average market
price of the common shares.
Due to the net loss attributable for the three and six months ended June
30, 2001 on a diluted basis to common stockholders, stock options and warrants
have been excluded from the diluted earnings per share calculation as their
inclusion would have been antidilutive. Had net income been reported for the six
months ended June 30, 2001, an additional 13,950,739 shares would have been
added to dilute potential common shares. The weighted average exercise price of
the outstanding stock options and common stock warrants at June 30, 2002 and
2001 was $2.05 and $2.12, respectively.
Note 9. Comprehensive Income (Loss)
Comprehensive income (loss) consists of the following:
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
2002 2001 2002 2001
-------- -------- -------- --------
(Dollars in thousands)
Net income (loss) ........ $ 20,868 $(12,398) $ 22,363 $(20,826)
Other comprehensive loss,
net of income taxes:
Foreign currency trans-
lation adjustments . (35) (24) (17) (46)
-------- -------- -------- --------
Total comprehensive
income (loss) ...... $ 20,833 $(12,422) $ 22,346 $(20,872)
======== ======== ======== ========
During the three and six months ended June 30, 2002 and 2001, the net
effect of income taxes on comprehensive loss was immaterial.
13
Note 10. Related Parties
Amounts receivable from and payable to related parties are as follows:
June 30, December 31,
2002 2001
-------- --------
(Dollars in thousands)
Receivables from related parties:
Virgin ............................... $ 7,716 $ 7,504
Vivendi .............................. 3,634 2,437
Titus ................................ 158 260
Return allowance ..................... (4,445) (4,026)
-------- --------
Total ................................ $ 7,063 $ 6,175
======== ========
Payables to related parties:
Virgin ............................... $ 6,593 $ 5,790
Vivendi .............................. 1,116 --
Titus ................................ 2,470 1,308
-------- --------
Total ................................ $ 10,179 $ 7,098
======== ========
Distribution and Publishing Agreements
Titus Interactive S.A.
In connection with the equity investments by Titus, the Company performs
distribution services on behalf of Titus for a fee. In connection with such
distribution services, the Company recognized fee income of $19,000 and $7,000
for the three months ended June 30, 2002 and 2001, respectively. For the six
months ended June 30, 2002 and 2001, the Company recognized fee income of
$19,000 and $28,000, respectively.
Amounts due to Titus at June 30, 2002 and December 31, 2001 include
dividends payable of $2.0 million and $0.7 million, respectively. Amounts due to
Titus at December 31, 2001 include $0.5 million for expenses incurred by Titus
on behalf of the Company.
Virgin Interactive Entertainment Limited
Under an International Distribution Agreement with Virgin Interactive
Entertainment Limited ("Virgin"), a wholly owned subsidiary of Titus, Virgin
provides for the exclusive distribution of substantially all of the Company's
products in Europe, Commonwealth of Independent States, Africa and the Middle
East for a seven-year period, cancelable under certain conditions, subject to
termination penalties and costs. Under the Agreement, the Company pays Virgin a
monthly overhead fee, certain minimum operating charges, a distribution fee
based on net sales, and Virgin provides certain market preparation, warehousing,
sales and fulfillment services on behalf of the Company.
Under the terms of the amended International Distribution Agreement, the
Company pays Virgin a monthly overhead fee of $83,000 per month for the six
month period beginning January 2002, with no further overhead commitment for the
remainder of the term of the International Distribution Agreement.
In connection with the International Distribution Agreement, the Company
incurred distribution commission expense of $0.2 million and $0.3 million for
the three months ended June 30, 2002 and 2001, respectively. For the six months
ended June 30, 2002 and 2001, the Company incurred distribution expense of $0.3
million and $0.6 million, respectively. In addition, the Company recognized
overhead fees of $0.3 million and zero dollars for the three months ended June
30, 2002 and 2001, respectively, and $0.5 million and $0.3 million for the six
months ended June 30, 2002 and 2001 respectively.
14
Under a Product Publishing Agreement with Virgin, as amended, the Company
has an exclusive license to publish and distribute one future product release
within North America, Latin America and South America for a royalty based on net
sales. In connection with the Product Publishing Agreement with Virgin, the
Company earned $39,000 and zero for performing publishing and distribution
services on behalf of Virgin for the three months ended June 30, 2002 and 2001,
respectively. For the six months ended June 30, 2002 and 2001, the Company
earned $39,000 and $15,000, respectively, for performing publishing and
distribution services.
In connection with the International Distribution Agreement, the Company
subleases office space from Virgin. Rent expense paid to Virgin was $27,000 and
$27,000 for the three months ended June 30, 2002 and 2001 and for the six months
ended June 30, 2002, the Company paid $54,000 and $54,000, respectively.
Vivendi Universal Games, Inc.
In connection with the distribution agreement with Vivendi, the Company
incurred distribution commission expense of $1.7 million and $2.6 million for
the three and six months ended June 30, 2002, respectively.
Note 11. Segment and Geographical Information
The Company operates in one principal business segment, which is managed
primarily from the Company's U. S. headquarters.
Net revenues by geographic regions were as follows:
Three months Ended June 30, Six Months Ended June 30,
2002 2001 2002 2001
---------------- ---------------- ---------------- ----------------
Amount Percent Amount Percent Amount Percent Amount Percent
------- ------- ------- ------- ------- ------- ------- -------
(Dollars in thousands)
North America .. $ 8,103 68% $ 9,441 66% $12,569 46% $22,897 74%
Europe ......... 1,643 14% 2,482 18% 2,946 11% 3,820 12%
Rest of World .. 121 1% 914 6% 268 1% 1,579 5%
OEM, royalty and
licensing ... 1,975 17% 1,465 10% 11,434 42% 2,819 9%
------- --- ------- --- ------- --- ------- ---
$11,842 100% $14,302 100% $27,217 100% $31,115 100%
======= === ======= === ======= === ======= ===
Note 12. Other Expense, net
In April 2002, the Company entered into a settlement agreement with the
landlord of an office facility in the United Kingdom, whereby the Company
returned the property back to the landlord and was released from any further
lease obligations. As a result of this settlement, the Company reduced its
amounts accrued for this contractual cash obligation by $0.8 million for the six
months ended June 30, 2002.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Cautionary Statement
The information contained in this Form 10-Q is intended to update the
information contained in the Company's Annual Report on Form 10-K for the year
ended December 31, 2001 and presumes that readers have access to, and will have
read, the "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and other information contained in such Form 10-K.
This Form 10-Q contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities and Exchange Act of 1934 and such forward-looking statements are
subject to the safe harbors created thereby. For this purpose, any statements
contained in this Form 10-Q, except for historical information, may be deemed to
be forward-looking statements. Without limiting the generality of the foregoing,
words such as "may," "will," "expect," "believe," "anticipate," "intend,"
"could," "should," "estimate" or "continue" or the negative or other variations
thereof or comparable terminology are intended to identify forward-looking
statements. In addition, any statements that refer to expectations, projections
or other characterizations of future events or circumstances are forward-looking
statements.
The forward-looking statements included herein are based on current
expectations that involve a number of risks and uncertainties, as well as on
certain assumptions. For example, any statements regarding future cash flow,
financing activities and cost reduction measures are forward-looking statements
and there can be no assurance that the Company will achieve its operating plans
or generate positive cash flow in the future, arrange adequate financing or
complete strategic transactions on satisfactory terms, if at all, or that any
cost reductions effected by the Company will be sufficient to offset any
negative cash flow from operations. Additional risks and uncertainties include
possible delays in the completion of products, the possible lack of consumer
appeal and acceptance of products released by the Company, fluctuations in
demand for the Company's products, lost sales because of the rescheduling of
products launched or orders delivered, failure of the Company's markets to
continue to grow, that the Company's products will remain accepted within their
respective markets, that competitive conditions within the Company's markets
will not change materially or adversely, that the Company will retain key
development and management personnel, that the Company's forecasts will
accurately anticipate market demand and that there will be no material adverse
change in the Company's operations or business. Additional factors that may
affect future operating results are discussed in more detail in "Factors
Affecting Future Performance" below as well as the Company's Annual Report on
Form 10-K on file with the Securities and Exchange Commission. Assumptions
relating to the foregoing involve judgments with respect to, among other things,
future economic, competitive and market conditions, and future business
decisions, all of which are difficult or impossible to predict accurately and
many of which are beyond the control of the Company. Although the Company
believes that the assumptions underlying the forward-looking statements are
reasonable, the business and operations of the Company are subject to
substantial risks that increase the uncertainty inherent in the forward-looking
statements, and the inclusion of such information should not be regarded as a
representation by the Company or any other person that the objectives or plans
of the Company will be achieved. In addition, risks, uncertainties and
assumptions change as events or circumstances change. The Company disclaims any
obligation to publicly release the results of any revisions to these
forward-looking statements which may be made to reflect events or circumstances
occurring subsequent to the filing of this Form 10-Q with the SEC or otherwise
to revise or update any oral or written forward-looking statement that may be
made from time to time by or on behalf of the Company.
Management's Discussion of Critical Accounting Policies
Our discussion and analysis of our 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 revenue recognition, prepaid licenses and royalties and software
development costs. 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
16
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions. We believe the
following critical accounting policies affect our more significant judgments and
estimates used in preparation of our consolidated financial statements.
Revenue Recognition
We record revenues when we deliver products to customers in accordance with
Statement of Position ("SOP") 97-2, "Software Revenue Recognition." and SEC
Staff Accounting Bulletin No. 101, Revenue Recognition. With the signing of the
Vivendi distribution agreement in August 2001, substantially all of our sales
are made by two related party distributors. The Company recognizes revenue from
sales by distributors, net of sales commissions, only as the distributor
recognizes sales of the Company's products to unaffiliated third parties. For
those agreements that provide the customers the right to multiple copies of a
product in exchange for guaranteed amounts, we recognize revenue at the delivery
of the product master or the first copy. We recognize per copy royalties on
sales that exceed the guarantee as copies are duplicated. We generally are not
contractually obligated to accept returns, except for defective, shelf-worn and
damaged products. However, on a case-by-case negotiated basis, we permit
customers to return or exchange product and may provide price concessions to our
retail distribution customers on unsold or slow moving products. In accordance
with Statement of Financial Accounting Standards ("SFAS") No. 48, "Revenue
Recognition when Right of Return Exists," we record revenue net of a provision
for estimated returns, exchanges, markdowns, price concessions, and warranty
costs. We record such reserves based upon management's evaluation of historical
experience, current industry trends and estimated costs. During 2001, we
substantially increased our sales allowances as a result of the granting of
price concessions to resellers on products in their inventory, in an effort to
minimize product returns following the transition of our North American
distribution rights to Vivendi. As a result, sales allowances as a percentage of
our total accounts receivable increased to 44 percent at December 31, 2001 from
19 percent at December 31,2000. The amount of reserves ultimately required could
differ materially in the near term from the amounts provided in the accompanying
consolidated financial statements. We provide customer support only via
telephone and the Internet. Customer support costs are not material and we
charge such costs to expenses as we incur them. We also expect to engage in the
sale of licensing rights on certain products. The terms of the licensing rights
differ, but normally include the right to develop and distribute a product on a
specific video game platform. Revenue is recognized when the rights have been
transferred and no other obligations exist.
Prepaid Licenses and Royalties
Prepaid licenses and royalties consist of license fees paid to intellectual
property rights holders for use of their trademarks or copyrights. Also included
in prepaid royalties are prepayments made to independent software developers
under developer arrangements that have alternative future uses. These payments
are contingent upon the successful completion of milestones, which generally
represent specific deliverables. Royalty advances are recoupable against future
sales based upon the contractual royalty rate. We amortize the cost of licenses,
prepaid royalties and other outside production costs to cost of goods sold over
six months commencing with the initial shipment in each region of the related
title. We amortize these amounts at a rate based upon the actual number of units
shipped with a minimum amortization of 75 percent in the first month of release
and a minimum of 5 percent for each of the next five months after release. This
minimum amortization rate reflects our typical product life cycle. Management
evaluates the future realization of such costs quarterly and charges to cost of
goods sold any amounts that management deems unlikely to be fully realized
through future sales. Such costs are classified as current and noncurrent assets
based upon estimated product release date.
Software Development Costs
Our internal research and development costs, which consist primarily of
software development costs, are expensed as incurred. Statement of Financial
Accounting Standards ("SFAS") No. 86, "Accounting for the Cost of Computer
Software to be Sold, Leased, or Otherwise Marketed", provides for the
capitalization of certain software development costs incurred after
technological feasibility of the software is established or for development
costs that have alternative future uses. Under our current practice of
developing new products, the technological feasibility of the underlying
software is not established until substantially all of the product development
is complete. As a result,
17
we have not capitalized any software development costs on internal development
projects, as the eligible costs were determined to be insignificant.
Other Significant Accounting Policies
Other significant accounting policies not involving the same level of
measurement uncertainties as those discussed above, are nevertheless important
to an understanding of the financial statements. The policies related to
consolidation and loss contingencies require difficult judgments on complex
matters that are often subject to multiple sources of authoritative guidance.
Certain of these matters are among topics currently under reexamination by
accounting standards setters and regulators. Although no specific conclusions
reached by these standard setters appear likely to cause a material change in
our accounting policies, outcomes cannot be predicted with confidence. Also see
Note 1 of Notes to Consolidated Financial Statements, Summary of Significant
Accounting Policies, which discusses accounting policies that must be selected
by management when there are acceptable alternatives.
Results of Operations
The following table sets forth certain selected consolidated statements of
operations data, segment data and platform data for the periods indicated in
dollars and as a percentage of total net revenues:
Three Months Ended June 30, Six Months Ended June 30,
2002 2001 2002 2001
-------------------- -------------------- -------------------- --------------------
% of Net % of Net % of Net % of Net
Amount Revenues Amount Revenues Amount Revenues Amount Revenues
-------- -------- -------- -------- -------- -------- -------- --------
(Dollars in thousands)
Net revenues ............ $ 11,842 100% $ 14,302 100% $ 27,217 100% $ 31,115 100%
Cost of goods sold ...... 10,602 90% 10,993 77% 15,079 55% 21,478 69%
-------- --- -------- --- -------- --- -------- ---
Gross profit ....... 1,240 10% 3,309 23% 12,138 45% 9,637 31%
-------- --- -------- --- -------- --- -------- ---
Operating expenses:
Marketing and sales 2,688 23% 5,325 37% 4,342 16% 11,511 37%
General and adminis-
trative .......... 1,819 15% 4,097 29% 4,835 18% 6,583 21%
Product development 3,848 32% 5,332 37% 8,546 31% 10,649 34%
-------- --- -------- --- -------- --- -------- ---
Total operating
expenses ......... 8,355 70% 14,754 103% 17,723 65% 28,743 92%
-------- --- -------- --- -------- --- -------- ---
Operating income (loss) . (7,115) -60% (11,445) -80% (5,585) -20% (19,106) -61%
Sale of Shiny ........... 28,781 243% -- 0% 28,781 106% -- 0%
Other expense ........... (873) -7% (953) -7% (908) -3% (1,720) -6%
-------- --- -------- --- -------- --- -------- ---
Income (loss) before
income taxes ....... 20,793 176% (12,398) -87% 22,288 82% (20,826) -67%
(Benefit) provision for
income taxes ....... (75) -1% -- 0% (75) 0% -- 0%
-------- --- -------- --- -------- --- -------- ---
Net income (loss) ....... $ 20,868 175% $(12,398) -87% $ 22,363 82% $(20,826) -67%
======== === ======== === ======== === ======== ===
Net revenues by geo-
graphic region:
North America ...... $ 8,103 68% $ 9,441 66% $ 12,569 46% $ 22,897 74%
International ...... 1,764 15% 3,396 24% 3,214 12% 5,399 17%
OEM, royalty and
licensing ........ 1,975 17% 1,465 10% 11,434 42% 2,819 9%
Net revenues by platform:
Personal computer .. $ 2,664 22% $ 11,810 83% $ 6,945 26% $ 23,769 76%
Video game console . 7,203 61% 1,027 7% 8,838 32% 4,527 15%
OEM, royalty and
licensing ........ 1,975 17% 1,465 10% 11,434 42% 2,819 9%
18
North American, International and OEM, Royalty and Licensing Net Revenues
Net revenues for the three months ended June 30, 2002 were $11.8 million, a
decrease of 17 percent compared to the same period in 2001. This decrease
resulted from a 14 percent decrease in North American net revenues and a 48
percent decrease in International net revenues offset by a 35 percent increase
in OEM, royalties and licensing revenues.
North American net revenues for the three months ended June 30, 2002 were
$8.1 million. The decrease in North American net revenues in 2002 was mainly due
to releasing only one title in 2002 compared to 4 titles in 2001 resulting in a
decrease in North American sales of $2.3 million, partially offset by a decrease
in product returns and price concessions of $1.0 million as compared to the 2001
period. The decrease in title releases across all platforms is a result of our
continued focus on product planning and the releasing of fewer and higher
quality titles.
International net revenues for the three months ended June 30, 2002 were
$1.8 million. The decrease in International net revenues for the three months
ended June 30, 2002 was mainly due to the reduction in title releases during the
year which resulted in a $2.5 million decrease in revenue offset by a decrease
in product returns and price concessions of $0.9 million compared to the 2001
period. Our product planning efforts during 2002 also contributed to the
reduction of titles released in the International markets.
Net revenues for the six months ended June 30, 2002 were $27.2 million, a
decrease of 13 percent compared to the same period in 2001. This decrease
resulted from a 45 percent decrease in North American net revenues, a 40 percent
decrease in International net revenues offset by a 306 percent increase in OEM,
royalties and licensing revenues.
North American net revenues for the six months ended June 30, 2002 were
$12.6 million. The decrease in North American net revenues in 2002 was mainly
due to releasing one title in 2002 compared to 7 titles in 2001 resulting in a
decrease in North American sales of $12.8 million, partially offset by a
decrease in product returns and price concessions of $2.5 million as compared to
the 2001 period. The decrease in title releases across all platforms is a result
of our continued focus on product planning and the releasing of fewer and higher
quality titles.
International net revenues for the six months ended June 30, 2002 were $3.2
million. The decrease in International net revenues for the six months ended
June 30, 2002 was mainly due to the reduction in title releases during the year
which resulted in a $5.1 million decrease in revenue offset by a decrease in
product returns and price concessions of $2.9 million compared to the 2001
period. Our product planning efforts during 2002 also contributed to the
reduction of titles released in the International markets.
We expect that both our North American and International publishing net
revenues in fiscal 2002 will increase compared to fiscal 2001, as we anticipate
releasing more major titles than in 2001. We currently have 5 to 6 titles
scheduled for release during the remainder of the year.
OEM, royalty and licensing net revenues for the three months ended June 30,
2002 were $2.0 million, an increase of $0.5 million as compared to the same
period in 2001. OEM net revenues increased by $0.3 million compared to the 2001
period and licensing net revenues increased by $0.2 million as compared to the
2001 period.
OEM, royalty and licensing net revenues for the six months ended June 30,
2002 were $11.4 million, an increase of $8.6 million as compared to the same
period in 2001. The OEM business increased by $0.5 million compared to the same
period in 2001. The six months ended June 30, 2002 also included revenues
related to the sale of publishing rights for one of our products and the
recognition of deferred revenue for a licensing transaction. In January 2002, we
sold the publishing rights to this title to the distributor in connection with a
settlement agreement entered into with the third party developer. The settlement
agreement provided, among other things, that we assign our rights and
obligations under the product agreement to the third party distributor. As a
result, we recorded net revenues of $5.6 million in the six months ended June
30, 2002. In February 2002, a licensing transaction we entered into in 1999
expired and we recognized revenue of $1.2 million, the unearned portion of the
minimum guarantee. Excluding the above transactions, our licensing revenues for
the six months ended June 30, 2002 increased by $1.3 million as compared to the
2001 period.
19
We expect that OEM, royalty and licensing net revenues in fiscal 2002 will
increase compared to fiscal 2001 as a result of these two transactions combined
with a consistent level of OEM business.
Platform Net Revenues
PC net revenues for the three months ended June 30, 2002 were $2.7 million,
a decrease of 77 percent compared to the same period in 2001. The decrease in PC
net revenues in 2002 was primarily due to not releasing any titles in 2002 as
compared to four titles released in 2001. Video game console net revenues were
$7.2 million, an increase of 601 percent for the three months ended June 30,
2002 compared to the same period in 2001, due to releasing the major hit title
Hunter: The Reckoning (Xbox) in 2002 as compared to the international release on
one title in 2001.
PC net revenues for the six months ended June 30, 2002 were $6.9 million, a
decrease of 71 percent compared to the same period in 2001. The decrease in PC
net revenues in 2002 was primarily due to not releasing any titles in 2002 as
compared to six titles released in 2001. Video game console net revenues were
$8.8 million an increase of 95 percent for the six months ended June 30, 2002
compared to the same period in 2001, due to releasing the major hit title
Hunter: The Reckoning (Xbox) in 2002 as compared to one title in 2001.
We expect our PC net revenues to decrease in 2002 as compared to 2001 as we
expect to release only two to three new titles as we continue to focus more on
next generation console products. We anticipate releasing five new console
titles in fiscal 2002 and expect net revenues to increase in fiscal 2002 partly
due to the fact that we anticipate releasing the major hit title Baldur's Gate:
Dark Alliance on Xbox and Gamecube in the latter half of 2002.
Cost of Goods Sold; Gross Profit Margin
Our cost of goods sold decreased 4 percent to $10.6 million in the three
months ended June 30, 2002 compared to the same period in 2001. The decrease was
primarily due to the decrease in overall product sales during the period,
partially offset by a change in the mix of sales from PC products, which have a
lower cost of goods per unit, to console products, which have a higher cost of
goods per unit. Our gross margin decreased to 10 percent for 2002 from 26
percent in 2001. This was primarily due to an increase in console net revenues
and both periods were negatively impacted by higher amortization of prepaid
royalties on externally developed products, including approximately $2.1 million
in 2002 and $1.5 million in 2001 in write-offs of canceled development projects.
Our cost of goods sold decreased 30 percent to $15.1 million in the six
months ended June 30, 2002 compared to the same period in 2001. The decrease was
primarily due to the decrease in overall product sales during the period,
partially offset by a change in the mix of sales from PC products, which have a
lower cost of goods per unit, to console products, which have a higher cost of
goods per unit. Our gross margin increased to 45 percent for 2002 from 33
percent in 2001. This was due to the publishing and licensing transactions in
2002, which did not bear any significant cost of goods. Both periods were
negatively impacted by higher amortization of prepaid royalties on externally
developed products, including approximately $2.1 million in 2002 and $2.2
million in 2001 in write-offs of canceled development projects.
We expect our gross profit margin and gross profit to increase in fiscal
2002 as compared to fiscal 2001 as we expect not to incur any significant,
unusual product returns and price concessions or any additional write-offs of
prepaid royalties in 2002.
Marketing and Sales
Marketing and sales expenses primarily consist of advertising and retail
marketing support, sales commissions, marketing and sales personnel, customer
support services and other related operating expenses. Marketing and sales
expenses for the three months ended June 30, 2002 were $2.7 million, a 50
percent decrease as compared to the 2001 period. The decrease in marketing and
sales expenses is due to a $1.2 million reduction in advertising and retail
marketing support expenditures due to releasing fewer titles in 2002 and a $1.5
million decrease in personnel costs and general expenses due in part to our
shift from a direct sales force for North America to a distribution
20
arrangement with Vivendi. The decrease in marketing and sales expenses included
a $0.1 million decrease in overhead fees paid to Virgin under our April 2001
settlement with Virgin (See Activities with Related Parties).
Marketing and sales expenses for the six months ended June 30, 2002 were
$4.3 million, a 62 percent decrease as compared to the 2001 period. The decrease
in marketing and sales expenses is due to a $4.5 million reduction in
advertising and retail marketing support expenditures due to releasing fewer
titles in 2002 and a $2.7 million decrease in personnel costs and general
expenses due in part to our shift from a direct sales force for North America to
a distribution arrangement with Vivendi. The decrease in marketing and sales
expenses was partially offset by $0.2 million increase in overhead fees paid to
Virgin under our April 2001 settlement with Virgin (See Activities with Related
Parties).
We expect our marketing and sales expenses to decrease in fiscal 2002
compared to fiscal 2001, due to fewer overall planned title releases in fiscal
2002 across all platforms, lower personnel costs from our reduced headcount and
a reduction in overhead fees paid to Virgin pursuant to the April 2001
settlement.
General and Administrative
General and administrative expenses primarily consist of administrative
personnel expenses, facilities costs, professional fees, bad debt expenses and
other related operating expenses. General and administrative expenses for the
three months ended June 30, 2002 were $1.8 million, a 56 percent decrease as
compared to the same period in 2001. The decrease is due to a $2.3 million
decrease in personnel costs and general expenses.
General and administrative expenses for the six months ended June 30, 2002
were $4.8 million, a 27 percent decrease as compared to the same period in 2001.
The decrease is due to a $1.8 million decrease in personnel costs and general
expenses. In the 2002 period we incurred significant charges of $0.4 million in
loan termination fees associated with the termination of our line of credit and
$0.5 million in consulting expenses payable to our investment bankers, Europlay,
incurred to assist us with the restructuring of the company. In the 2001 period
significant charges of $0.6 million provision for the termination of a building
lease in the United Kingdom and $0.5 million in legal, audit and investment
banking fees and expenses incurred principally in connection with the efforts of
a proposed sale of the Company which was terminated.
We expect our general and administrative expenses to decrease in fiscal
2002 compared to fiscal 2001 primarily due to the reduction in headcount and the
continued reduction in other related costs.
Product Development
Product development expenses for the three months ended June 30, 2002 were
$3.8 million, a 28 percent decrease as compared to the same period in 2001. This
decrease is due to a $1.5 million decrease in personnel costs as a result of a
reduction in headcount and the sale of Shiny Entertainment, Inc. in April 2002.
Product development expenses for the six months ended June 30, 2002 were
$8.5 million, a 20 percent decrease as compared to the same period in 2001. This
decrease is due to a $2.1 million decrease in personnel costs as a result of a
reduction in headcount and the sale of Shiny.
We expect our product development expenses to decrease in fiscal 2002
compared to fiscal 2001 as a result of lower headcount and the sale of Shiny.
Sale of Shiny Entertainment, Inc.
In April 2002, we sold our former subsidiary Shiny Entertainment, Inc. to
Infogrames for $47.2 million. After recognizing closing costs, consideration to
Warner Brothers for their consent to transfer the Matrix license and expensing
amounts previously paid for the Matrix license, we recognized a gain of $28.8
million on this sale.
21
Other Expense, net
Other expenses for the three months ended June 30, 2002 were $0.9 million,
an 8 percent decrease as compared to the same period in 2001. The decrease was
due to no interest expense related to lower net borrowings on our line of
credit, no losses associated with foreign currency exchanges offset by an
increase of $0.5 million penalty due to a delay in the effectiveness of a
registration statement in connection with our private placement of our common
stock.
Other expenses for the six months ended June 30, 2002 were $0.9 million, a
47 percent decrease as compared to the same period in 2001. The decrease was due
to no interest expense related to lower net borrowings on our line of credit, no
losses associated with foreign currency exchanges and $0.9 million associated
with a gain in the settlement and termination of a building lease in the United
Kingdom offset by an increase of $1.3 million penalty due to a delay in the
effectiveness of a registration statement in connection with our private
placement of our common stock.
Benefit from Income Taxes
In June 2002, the Internal Revenue Service concluded their examination
of our consolidated federal income tax returns for the years ended April 30,
1992 through 1997. In fiscal 2001, we established a reserve of $500,000,
representing management's best estimate of amounts to be paid in settlement of
the IRS claims. In the second quarter of 2002, we reached a settlement with the
IRS and agreed to pay $275,000 to settle all outstanding issues. With the
executed settlement, we have adjusted our reserve and, as a result, recorded an
income tax benefit of $225,000. This benefit was offset by an income tax
provision of $150,000 associated with the gain on sale of Shiny.
Liquidity and Capital Resources
We have funded our operations to date primarily through the use of
borrowings, royalty and distribution fee advances, cash generated by the private
sale of securities, proceeds of the initial public offering, the sale of assets
and from results of operations.
As of June 30, 2002, our cash balance was approximately $157,000 and our
outstanding accounts payable and current debt totaled approximately $38.6
million, with approximately $10.2 million that can be offset against receivable
balances. On April 30, 2002, in connection with the sale of Shiny, we received a
cash payment of approximately $3.0 million and a promissory note in the
principal amount of approximately $10.8 million payable over three months, and
applied additional proceeds to repay approximately $26.1 million in accounts
payable and current debt including $11.5 million of prepaid advances that were
accelerated as a condition of the transaction. We expect that we will need to
substantially reduce our working capital needs and/or raise additional
financing. Along these lines, we have entered into a new distribution agreement
with Vivendi, which accelerates cash collections through minimum guarantees. If
we do not receive sufficient financing we may (i) liquidate assets, (ii) sell
the company, (iii) seek protection from our creditors, and/or (iv) continue
operations, but incur material harm to our business, operations or financial
conditions.
Our primary capital needs have historically been to fund working capital
requirements necessary to fund our net losses, our sales growth, the development
and introduction of products and related technologies and the acquisition or
lease of equipment and other assets used in the product development process. Our
operating activities used cash of $22.7 million during the six months ended June
30, 2002, primarily attributable to payments for royalty liabilities, recoupment
of advances received by distributors and refund of advances received from
Vivendi and a console hardware manufacturer for the development of titles for
its console platform in connection with the sale of Shiny offset by net income
of $22.4 million and collections of accounts receivable and an increase in
payables to related parties.
Net cash used by financing activities of $4.7 million for the six months
ended June 30, 2002, consisted primarily of repayments of our working capital
line of credit and repayments to our former Chairman. Cash provided by investing
activities of $27.4 million for the six months ended June 30, 2002 consisted of
proceeds from the sale of Shiny, offset by normal capital expenditures,
primarily for office and computer equipment used in our operations. We do not
currently have any material commitments with respect to any future capital
expenditures.
22
The following summarizes our contractual obligations under non-cancelable
operating leases and other borrowings at June 30, 2002, and the effect such
obligations are expected to have on our liquidity and cash flow in future
periods.
Less
Than 1 - 3 After
June 30, 2002 Total 1 Year Years 3 Years
------ ------ ------ ------
(In thousands)
Contractual cash obligations:
Non-cancelable operating
lease obligations .............. 5,867 1,375 3,031 1,461
------ ------ ------ ------
Total contractual cash
obligations ....................... $5,867 $1,375 $3,031 $1,461
====== ====== ====== ======
In April 2002, we entered into a settlement agreement with the landlord of
an office facility in the United Kingdom, whereby we returned the property back
to the landlord and were released from any further lease obligations. This
settlement reduced our total contractual cash obligations by $1.3 million
through fiscal 2005.
Our main source of capital is from the release of new titles. Historically,
we have had some delays in the release of new titles and we anticipate that we
may continue to incur delays in the release of future titles. These delays can
have a negative impact on our short-term liquidity, but should not affect our
overall liquidity.
To reduce our working capital needs, we have implemented various measures
including a reduction of personnel, a reduction of fixed overhead commitments,
cancellation or suspension of development on future titles, which management
believes do not meet sufficient projected profit margins, and the scaling back
of certain marketing programs associated with the cancelled projects. Management
will continue to pursue various alternatives to improve future operating results
and further expense reductions, some of which may have a long-term adverse
impact on our ability to generate successful future business activities. In
addition, we continue to seek external sources of funding, including but not
limited to, a sale or merger of the company, a private placement of our capital
stock, the sale of selected assets, the licensing of certain product rights in
selected territories, selected distribution agreements, and/or other strategic
transactions sufficient to provide short-term funding, and potentially achieve
our long-term strategic objectives. In this regard, we completed the sale of
Shiny in April 2002, for approximately $47.2 million. Additionally, in August
2002, our Board of Directors established a Special Committee comprised of
directors that are independent of our largest stockholder, Titus Interactive
S.A., to investigate strategic options, including raising capital from the sale
of debt or equity securities and a sale of the company.
In order to improve our cash flow, in August 2002, we entered into a new
distribution arrangement with Vivendi whereby Vivendi will pay us sales proceeds
based on Vivendi's sales of the products less amounts for distribution fees,
price concessions and returns, inventory and marketing costs. Upon the delivery
of a gold master to Vivendi, Vivendi will pay us, as a minimum guarantee, 75
percent of the projected amount due to us based on projected initial shipment
sales, established by Vivendi in accordance with the terms of the agreement, and
the remaining amounts shall be due upon shipment of the titles to Vivendi's
customers. Any future sales exceeding the initial shipment will be paid on a
monthly basis. We expect this new arrangement to improve our short-term
liquidity, but should not impact our overall liquidity.
If operating revenues from product releases are not sufficient to fund our
operations, no assurance can be given that alternative sources of funding could
be obtained on acceptable terms, or at all. These conditions, combined with our
historical operating losses and deficits in stockholders' equity and working
capital, raise substantial doubt about our ability to continue as a going
concern. The accompanying consolidated financial statements do not include any
adjustments to reflect the possible future effects on the recoverability and
classification of assets and liabilities that may result from the outcome of
this uncertainty.
Activities with Related Parties
Our operations involve significant transactions with Titus, our majority
stockholder, Virgin, a wholly-owned subsidiary of Titus, and Vivendi, an
indirect owner of 5 percent of our common stock. In addition, we previously
obtained financing from the former Chairman of the company.
23
Transactions with Titus
In March 2002, Titus converted its remaining 383,354 shares of Series A
preferred stock into approximately 47.5 million shares of our common stock.
Titus now owns approximately 67 million shares of common stock, which represents
approximately 72 percent of our outstanding common stock, our only voting
security, immediately following the conversion.
Titus retained Europlay as consultants to assist with the restructuring of
the company. This arrangement with Europlay is with Titus, however, we agreed to
reimburse Titus for consulting expenses incurred on our behalf. In connection
with the sale of Shiny, we agreed to pay Europlay directly for their services
with the proceeds received from the sale, which Europlay received. We have also
entered into a commission-based agreement with Europlay where Europlay will
assist us with strategic transactions, such as debt or equity financing, the
sale of assets or an acquisition of the company. Under this arrangement,
Europlay assisted us with the sale of Shiny.
In connection with the equity investments by Titus, we perform distribution
services on behalf of Titus for a fee. In connection with such distribution
services, we recognized fee income of $19,000 and $28,000 for the six months
ended June 30, 2002 and 2001, respectively.
In March 2002, we entered into a distribution agreement with Titus pursuant
to which we granted to Titus the exclusive right to distribute one of our
products for the Sony Playstation console in North America, South America and
Central America in exchange for a minimum guarantee of $100,000 for the first
71,942 units of the product sold, plus $.69 per unit on any product sold above
the 71,942 units.
As of June 30, 2002 and December 31, 2001, Titus owed us $3.7 million and
$0.3 million, respectively, and we owed Titus $2.5 million and $1.3 million,
respectively. Amounts due from Titus include a $3.5 million note receivable and
amounts due to Titus at June 30, 2002 include dividends payable of $2.0 million,
of which $1.0 million was paid in July 2002. Amounts due to Titus at December
31, 2001 include dividends payable of $0.7 million and $0.5 million for services
rendered by Europlay.
In April 2002, we entered into an agreement with Titus, pursuant to which,
among other things, we sold to Titus all right, title and interest in the games
"EarthWorm Jim", "Messiah", "Wild 9", "R/C Stunt Copter", "Sacrifice", "MDK",
"MDK II", and "Kingpin", and Titus licensed from us the right to develop,
publish, manufacture and distribute the games "Hunter I", "Hunter II", "Icewind
Dale I", "Icewind Dale II", and "BG: Dark Alliance II" solely on Nintendo
Advance GameBoy game system for the life of the games. As consideration for
these rights, Titus issued to us a promissory note in the principal amount of
$3.5 million, which note bears interest at 8 percent per annum. The promissory
note is due on August 31, 2002, and may be paid, at Titus' option, in cash or in
shares of Titus common stock with a per share value equal to 90 percent of the
average trading price of Titus' common stock over the 5 days immediately
preceding the payment date. Pursuant to our April 26, 2002 agreement with Titus,
on or before July 25, 2002, we had the right to solicit offers from and
negotiate with third parties to sell the rights and licenses granted under the
April 26, 2002 agreement. If we had entered into a binding agreement with a
third party to sell these rights and licenses for an amount in excess $3.5
million, we would have rescinded the April 26, 2002 agreement with Titus and
recovered all rights granted and released Titus from all obligations thereunder.
The Company's efforts to enter into a binding agreement with a third party were
unsuccessful. Moreover, we have provided Titus with a guarantee under this
agreement, which provides that in the event Titus does not achieve gross sales
of at least $3.5 million by June 25, 2003, and the shortfall is not the result
of Titus' failure to use best commercial efforts, we will pay to Titus the
difference between $3.5 million and the actual gross sales achieved by Titus,
not to exceed $2 million. We currently maintain a $3.5 million note receivable
from Titus as well as a $3.5 million deferred revenue amount for the related
transaction.
Transactions with Virgin, a wholly owned subsidiary of Titus
In February 1999, we entered into an International Distribution Agreement
with Virgin, which provides for the exclusive distribution of substantially all
of our products in Europe, Commonwealth of Independent States, Africa and the
Middle East for a seven-year period, cancelable under certain conditions,
subject to termination penalties and costs. Under this agreement, as amended, we
pay Virgin a monthly overhead fee, certain minimum operating
24
charges, a distribution fee based on net sales, and Virgin provides certain
market preparation, warehousing, sales and fulfillment services on our behalf.
Under the April 2001 settlement, we pay Virgin a monthly overhead fee of
$83,000 per month for the six month period beginning January 2002, with no
further overhead commitment for the remainder of the term of the International
Distribution Agreement.
In connection with the International Distribution Agreement, we incurred
distribution commission expense of $0.3 million and $0.6 million for the six
months ended June 30, 2002 and 2001, respectively. In addition, we recognized
overhead fees of $0.5 million and $0.3 million for the six months ended June 30,
2002 and 2001, respectively.
We have also entered into a Product Publishing Agreement with Virgin, which
provides us with an exclusive license to publish and distribute substantially
all of Virgin's products within North America, Latin America and South America
for a royalty based on net sales. As part of terms of the April 2001 settlement
between Virgin and us, the Product Publishing Agreement was amended to provide
for us to publish only one future title developed by Virgin. In connection with
the Product Publishing Agreement with Virgin, we earned $39,000 and $15,000 for
performing publishing and distribution services on behalf of Virgin for the six
months ended June 30, 2002 and 2001, respectively.
In connection with the International Distribution Agreement, we sublease
office space from Virgin. Rent expense paid to Virgin was $54,000 and $54,000
for the six months ended June 30, 2002 and 2001, respectively.
As of June 30, 2002 and December 31, 2001, Virgin owed us $7.7 million and
$7.5 million, and we owed Virgin $6.6 million and $5.8 million, respectively.
Transactions with Vivendi
In connection with a distribution agreement with Vivendi, which indirectly
owns approximately 5 percent of our common stock at June 30, 2002 but does not
have representation on our Board of Directors, Vivendi is our distributor in
North America through December 31, 2002 for substantially all of our products,
with the exception of products with pre-existing distribution agreements and
certain selected future titles. Under the terms of the agreement, as amended,
Vivendi earns a distribution fee based on the net sales of the titles
distributed. Under the agreement, Vivendi made advance payments to us totaling
$16.5 million. As of August 1, 2002, Vivendi has fully recouped their advance
payments to us from product sales.
In connection with the distribution agreement with Vivendi, we incurred
distribution commission expense of $2.6 million and zero dollars for the six
months ended June 30, 2002 and 2001, respectively. As of June 30, 2002 and
December 31, 2001, Vivendi owed us $3.6 million and $2.4 million, respectively.
In April 2002, we entered into an agreement with Vivendi, pursuant to
which, among other things, the parties amended the terms of the August 13, 2001
distribution agreement, as amended, as follows: (i) Vivendi was repaid $6.5
million of their advances under the August 13, 2001 distribution agreement; (ii)
Vivendi maintains the exclusive distribution rights to our back-catalog titles,
including "Baldur's Gate: Dark Alliance" through December 31, 2002, plus a six
month sell-off period; (iii) Vivendi will maintain exclusive distribution rights
to our upcoming new titles to be released, which includes "Icewind Dale 2" for
PC and "Hunter" on the Microsoft X-Box game console for a term of 1 year from
the date of release of each new title, plus a 6 month sell-off period; (iv)
Vivendi will retain 100 percent of proceeds from the distribution of "Baldur's
Gate: Dark Alliance" until such time as the balance of Vivendi's advance under
the August 13, 2001 distribution agreement is fully recouped; and (iv) Vivendi's
distribution rights to any of our other titles under the August 13, 2001
distribution agreement were terminated. As of August 1, 2002, Vivendi fully
recouped its advance to us.
In August 2002, we entered into a new distribution arrangement with Vivendi
whereby Vivendi will distribute substantially all of our products in North
America. Under the Agreement, Vivendi will pay us sales proceeds less amounts
for distribution fees, price concessions and returns, inventory and marketing
costs. Upon the delivery of a
25
gold master to Vivendi, Vivendi will pay us, as a minimum guarantee, 75 percent
of the projected amount due to us based on projected initial shipment sales,
established by Vivendi in accordance with the terms of the agreement, and the
remaining amounts shall be due upon shipment of the titles to Vivendi's
customers. Any future sales exceeding the initial shipment will be paid on a
monthly basis. The new agreement with Vivendi has a term of three years.
Transactions with a Brian Fargo, a former officer of the Company
In connection with our working capital line of credit obtained in April
2001, we obtained a $2 million personal guarantee in favor of the bank, secured
by $1.0 million in cash, from Brian Fargo, the former Chairman of the company.
In addition, Mr. Fargo provided us with a $3 million loan, payable in May 2002,
with interest at 10 percent. In connection with the guarantee and loan, Mr.
Fargo received warrants to purchase 500,000 shares of our common stock at $1.75
per share, expiring in April 2011. In January 2002, the bank redeemed the $1.0
million in cash pledged by Mr. Fargo in connection with his personal guarantee,
and subsequently we agreed to pay that amount back to Mr. Fargo. The amount was
fully paid in April 2002 in connection with the sale of Shiny.
Recent Accounting Pronouncements
In April 2001, the Emerging Issues Task Force issued No. 00-25 ("EITF
00-25"), "Accounting for Consideration from a Vendor to a Retailer in Connection
with the Purchase or Promotion of the Vendor's Products", which states that
consideration from a vendor to a reseller of the vendor's products is presumed
to be a reduction of the selling prices of the vendor's products and, therefore,
should be characterized as a reduction of revenue when recognized in the
vendor's income statement. That presumption is overcome and the consideration
can be categorized as a cost incurred if, and to the extent that, a benefit is
or will be received from the recipient of the consideration. That benefit must
meet certain conditions described in EITF 00-25. We adopted the provision of
EITF 00-25 on January 1, 2002 and as a result net revenues and marketing
expenses were reduced by $1.0 million for the six months ended June 30, 2001.
The adoption of EITF 00-25 did not impact our net loss for the three months
ended June 30, 2001.
In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other
Intangible Assets" effective for fiscal years beginning after December 15, 2001.
Under the new rules all acquisition transactions entered into after June 30,
2001, must be accounted for on the purchase method and goodwill will no longer
be amortized but will be subject to annual impairment tests in accordance with
SFAS 142. Other intangible assets will continue to be amortized over their
useful lives. We adopted the new rules on accounting for goodwill and other
intangible assets January 1, 2002. Adoption of FAS 142 did not have a material
impact on our consolidated financial position or results of operations. Goodwill
amortization for the three months ended June 30, 2001 was $96,000. With the sale
of Shiny, we no longer have any goodwill assets.
In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 143, "Accounting for Asset Retirement Obligations." SFAS No. 143 addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. The provisions of SFAS No. 143 are effective for financial statements
issued for fiscal years beginning after June 15, 2002, with early application
encouraged and generally are to be applied prospectively. We do not expect the
adoption of SFAS No. 143 to have a material impact on our consolidated financial
position or results of operations.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and the
accounting and reporting provisions of APB Opinion No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," for the disposal of a segment of a business (as previously
defined in that Opinion). We adopted the provisions of SFAS No. 144 on January
1, 2002. The adoption of SFAS No. 144 did not have a material impact on our
consolidated financial position or results of operations.
26
FACTORS AFFECTING FUTURE PERFORMANCE
Our future operating results depend upon many factors and are subject to
various risks and uncertainties. Some of the risks and uncertainties which may
cause our operating results to vary from anticipated results or which may
materially and adversely affect our operating results are as follows:
WE CURRENTLY HAVE A NUMBER OF OBLIGATIONS THAT WE ARE UNABLE TO MEET WITHOUT
GENERATING ADDITIONAL REVENUES OR RAISING ADDITIONAL CAPITAL. IF WE CANNOT
GENERATE ADDITIONAL REVENUES OR RAISE ADDITIONAL CAPITAL IN THE NEAR FUTURE, WE
MAY BECOME INSOLVENT AND OUR STOCK WOULD BECOME ILLIQUID OR WORTHLESS.
As of June 30, 2002, our cash balance was approximately $157,000 and our
outstanding accounts payable and current debt totaled approximately $38.6
million, with approximately $10.2 million that can be offset against related
party accounts receivable balances. On April 30, 2002, in connection with the
sale of Shiny, we received a cash payment of approximately $3.0 million and a
promissory note in the principal amount of approximately $10.8 million payable
over three months, and applied additional proceeds to repay approximately $26.1
million in accounts payable and current debt including $11.5 million of prepaid
advances that were accelerated as a condition of the transaction. Even with the
proceeds we received in the Shiny sale, we will need to raise additional
financing. If we do not receive sufficient financing we may (i) liquidate
assets, (ii) seek or be forced into bankruptcy and/or (iii) continue operations,
but incur material harm to our business, operations or financial condition.
These measures could have a material adverse effect on our ability to continue
as a going concern. Additionally, because of our financial condition, our Board
of Directors has a duty to our creditors that may conflict with the interests of
our stockholders. When a Delaware corporation is operating in the vicinity of
insolvency, the Delaware courts have imposed upon the corporation's directors a
fiduciary duty to the corporation's creditors. If we cannot obtain additional
capital and become unable to pay our debts as they become due, our Board of
Directors may be required to make decisions that favor the interests of
creditors at the expense of our stockholders to fulfill its fiduciary duty. For
instance, we may be required to preserve our assets to maximize the repayment of
debts versus employing the assets to further grow our business and increase
shareholder value.
WE HAVE A HISTORY OF LOSSES, MAY NEVER GENERATE POSITIVE CASH FLOW FROM
OPERATIONS AND MAY HAVE TO FURTHER REDUCE OUR COSTS BY CURTAILING FUTURE
OPERATIONS.
For the six months ended June 30, 2002, our net loss from operations was
$5.6 million and for the year ended December 31, 2001, our net loss was $46.3
million. Since inception, we have incurred significant losses and negative cash
flow, and as of June 30, 2002 we had an accumulated deficit of $129 million. Our
ability to fund our capital requirements out of our available cash and cash
generated from our operations depends on a number of factors. Some of these
factors include the progress of our product development programs, the rate of
growth of our business, and our products' commercial success. If we cannot
generate positive cash flow from operations, we will have to continue to reduce
our costs and raise working capital from other sources. These measures could
include selling or consolidating certain operations, and delaying, canceling or
scaling back product development and marketing programs. These measures could
materially and adversely affect our ability to publish successful titles, and
may not be enough to permit us to operate profitability, or at all.
WE DEPEND, IN PART, ON EXTERNAL FINANCING TO FUND OUR CAPITAL NEEDS. IF WE ARE
UNABLE TO OBTAIN SUFFICIENT FINANCING ON FAVORABLE TERMS, WE MAY NOT BE ABLE TO
CONTINUE TO OPERATE OUR BUSINESS.
Historically, our business has not generated revenues sufficient to create
operating profits. To supplement our revenues, we have funded our capital
requirements with debt and equity financing. Our ability to obtain additional
equity or debt financing depends on a number of factors including our financial
performance, the overall conditions in our industry, and our credit rating. If
we cannot raise additional capital on favorable terms, we will have to reduce
our costs and sell or consolidate operations.
OUR STOCK PRICE MAY DECLINE SIGNIFICANTLY IF WE ARE DELISTED FROM THE NASDAQ
SMALLCAP MARKET.
On May 16, 2002, the listing of our common stock was moved from the Nasdaq
National Market System to the Nasdaq SmallCap Market System. We currently are
not in compliance with the listing requirements of the Nasdaq
27
SmallCap Market. Nasdaq notified us on August 14, 2002 that our securities will
be delisted from the Nasdaq SmallCap Market at the opening of business on August
22, 2002. We have requested a hearing before a Nasdaq Listing Qualifications
Panel to review the Staff's determination. The hearing request will stay the
delisting of our securities pending the Panel's decision. There can be no
assurance, however, that the Panel will grant our request for continued listing.
If our securities are delisted from the Nasdaq SmallCap Market, trading of our
common stock may be conducted in the over-the-counter market on the "pink
sheets" or, if available, the NASD's "Electronic Bulletin Board." In any of
those cases, investors could find it more difficult to buy or sell, or to obtain
accurate quotations as to the value of our common stock. The trading price per
share of our common stock likely would be reduced as a result.
TITUS INTERACTIVE SA CONTROLS A MAJORITY OF OUR VOTING STOCK AND CAN ELECT A
MAJORITY OF OUR BOARD OF DIRECTORS AND PREVENT AN ACQUISITION OF INTERPLAY THAT
IS FAVORABLE TO OUR OTHER STOCKHOLDERS.
On March 15, 2002, Titus converted its remaining 383,354 shares of Series A
Preferred Stock into approximately 47.5 million shares of our common stock.
Titus now owns approximately 67 million shares of common stock, which represents
approximately 72 percent of our outstanding common stock, our only voting
security, immediately following the conversion. As a consequence, Titus can
control substantially all matters requiring stockholder approval, including the
election of directors, subject to our stockholders' cumulative voting rights,
and the approval of mergers or other business combination transactions. At our
2001 annual stockholders meeting on September 18, 2001, Titus exercised its
voting power to elect a majority of our Board of Directors. Three of the seven
members of the Board are employees or directors of Titus, and Titus' Chief
Executive Officer serves as our President and interim Chief Executive Officer.
This concentration of voting power could discourage or prevent a change in
control that otherwise could result in a premium in the price of our common
stock.
A SIGNIFICANT PERCENTAGE OF OUR REVENUES DEPEND ON OUR DISTRIBUTORS' DILIGENT
SALES EFFORTS AND OUR DISTRIBUTORS' AND RETAIL CUSTOMERS' TIMELY PAYMENTS TO US.
Since February 1999, Virgin has been the exclusive distributor for most of
our products in Europe, the Commonwealth of Independent States, Africa and the
Middle East. Our agreement with Virgin expires in February 2006. In August 2001,
we entered into a Distribution Agreement with Vivendi Universal Games, Inc.,
(formerly known as Vivendi Universal Interactive Publishing North America), or
"Vivendi," pursuant to which Vivendi distributes substantially all our products
in North America, as well as in South America, South Africa, Korea, Taiwan and
Australia. Our agreement with Vivendi expires in December 2002.
Virgin and Vivendi each have exclusive rights to distribute our products in
substantial portions of the world. As a consequence, the distribution of our
products by Virgin and Vivendi will generate a substantial majority of our
revenues, and proceeds from Virgin and Vivendi from the distribution of our
products will constitute a substantial majority of our operating cash flows.
Therefore, our revenues and cash flows could fall significantly and our business
and financial results could suffer material harm if:
o either Virgin or Vivendi fails to deliver to us the full proceeds owed
us from distribution of our products;
o either Virgin or Vivendi fails to effectively distribute our products
in their respective territories; or
o either Virgin or Vivendi otherwise fails to perform under their
respective distribution agreement.
We typically sell to distributors and retailers on unsecured credit, with
terms that vary depending upon the customer and the nature of the product. We
confront the risk of non-payment from our customers, whether due to their
financial inability to pay us, or otherwise. In addition, while we maintain a
reserve for uncollectible receivables, the reserve may not be sufficient in
every circumstance. As a result, a payment default by a significant customer
could cause material harm to our business.
28
THE TERMINATION OF OUR EXISTING CREDIT AGREEMENT HAS RESULTED IN A SUBSTANTIAL
REDUCTION IN THE CASH AVAILABLE TO FINANCE OUR OPERATIONS.
Pursuant to our credit agreement with LaSalle Business Credit Inc., or
"LaSalle", entered into in April 2001, we agreed to certain covenants. In
October 2001, LaSalle notified us that the credit agreement was being terminated
as a result of our failure to comply with some of those covenants and we would
no longer be able to continue to draw on the credit facility to fund future
operations. Because we depend on a credit agreement to fund our operations,
LaSalle's termination of the credit agreement has significantly impeded our
ability to fund our operations and has caused material harm to our business. We
will need to enter into a new credit agreement to help fund our operations.
There can be no assurance that we will be able to enter into a new credit
agreement or that if we do enter into a new credit agreement, it will be on
terms favorable to us.
THE UNPREDICTABILITY OF FUTURE RESULTS MAY CAUSE OUR STOCK PRICE TO REMAIN
DEPRESSED OR TO DECLINE FURTHER.
Our operating results have fluctuated in the past and may fluctuate in the
future due to several factors, some of which are beyond our control. These
factors include:
o demand for our products and our competitors' products;
o the size and rate of growth of the market for interactive
entertainment software;
o changes in personal computer and video game console platforms;
o the timing of announcements of new products by us and our competitors
and the number of new products and product enhancements released by us
and our competitors;
o changes in our product mix;
o the number of our products that are returned; and
o the level of our international and original equipment manufacturer
royalty and licensing net revenues.
Many factors make it difficult to accurately predict the quarter in which
we will ship our products. Some of these factors include:
o the uncertainties associated with the interactive entertainment
software development process;
o approvals required from content and technology licensors; and
o the timing of the release and market penetration of new game hardware
platforms.
It is likely that in some future periods our operating results will not
meet the expectations of the public or of public market analysts. Any
unanticipated change in revenues or operating results is likely to cause our
stock price to fluctuate since such changes reflect new information available to
investors and analysts. New information may cause securities analysts and
investors to revalue our stock and this may cause fluctuations in our stock
price.
THERE ARE HIGH FIXED COSTS TO DEVELOPING OUR PRODUCTS. IF OUR REVENUES DECLINE
BECAUSE OF DELAYS IN THE INTRODUCTION OF OUR PRODUCTS, OR IF THERE ARE
SIGNIFICANT DEFECTS OR DISSATISFACTION WITH OUR PRODUCTS, OUR BUSINESS COULD BE
HARMED.
For the six months ended June 30, 2002, our net loss form operations was
$5.6 million. We have incurred significant net losses in recent periods,
including a net loss of $46.3 million for the year ended December 31, 2001. Our
losses stem partly from the significant costs we incur to develop our
entertainment software products. Moreover, a significant portion of our
operating expenses is relatively fixed, with planned expenditures based largely
29
on sales forecasts. At the same time, most of our products have a relatively
short life cycle and sell for a limited period of time after their initial
release, usually less than one year.
Relatively fixed costs and short windows in which to earn revenues mean
that sales of new products are important in enabling us to recover our
development costs, to fund operations and to replace declining net revenues from
older products. Our failure to accurately assess the commercial success of our
new products, and our delays in releasing new products, could reduce our net
revenues and our ability to recoup development and operational costs.
IF OUR PRODUCTS DO NOT ACHIEVE BROAD MARKET ACCEPTANCE, OUR BUSINESS COULD BE
HARMED SIGNIFICANTLY.
Consumer preferences for interactive entertainment software are always
changing and are extremely difficult to predict. Historically, few interactive
entertainment software products have achieved continued market acceptance.
Instead, a limited number of releases have become "hits" and have accounted for
a substantial portion of revenues in our industry. Further, publishers with a
history of producing hit titles have enjoyed a significant marketing advantage
because of their heightened brand recognition and consumer loyalty. We expect
the importance of introducing hit titles to increase in the future. We cannot
assure you that our new products will achieve significant market acceptance, or
that we will be able to sustain this acceptance for a significant length of time
if we achieve it.
We believe that our future revenue will continue to depend on the
successful production of hit titles on a continuous basis. Because we introduce
a relatively limited number of new products in a given period, the failure of
one or more of these products to achieve market acceptance could cause material
harm to our business. Further, if our products do not achieve market acceptance,
we could be forced to accept substantial product returns or grant significant
pricing concessions to maintain our relationship with retailers and our access
to distribution channels. If we are forced to accept significant product returns
or grant significant pricing concessions, our business and financial results
could suffer material harm.
OUR RELIANCE ON THIRD PARTY SOFTWARE DEVELOPERS SUBJECTS US TO THE RISKS THAT
THESE DEVELOPERS WILL NOT SUPPLY US WITH HIGH QUALITY PRODUCTS IN A TIMELY
MANNER OR ON ACCEPTABLE TERMS.
Third party interactive entertainment software developers develop many of
our software products. Since we depend on these developers in the aggregate, we
remain subject to the following risks:
o limited financial resources may force developers out of business prior
to their completion of projects for us or require us to fund
additional costs; and
o the possibility that developers could demand that we renegotiate our
arrangements with them to include new terms less favorable to us.
Increased competition for skilled third party software developers also has
compelled us to agree to make advance payments on royalties and to guarantee
minimum royalty payments to intellectual property licensors and game developers.
Moreover, if the products subject to these arrangements, are not delivered
timely, or with acceptable quality, or do not generate sufficient sales volumes
to recover these royalty advances and guaranteed payments, we would have to
write-off unrecovered portions of these payments, which could cause material
harm to our business and financial results.
IF WE FAIL TO ANTICIPATE CHANGES IN VIDEO GAME PLATFORMS AND TECHNOLOGY, OUR
BUSINESS MAY BE HARMED.
The interactive entertainment software industry is subject to rapid
technological change. New technologies could render our current products or
products in development obsolete or unmarketable. Some of these new technologies
include:
o operating systems such as Microsoft Windows XP;
o technologies that support games with multi-player and online features;
o new media formats such as online delivery and digital video disks, or
DVDs; and
30
o recent releases of new video game consoles such as the Sony
Playstation 2, the Nintendo Gamecube and the Microsoft Xbox.
We must continually anticipate and assess the emergence of, and market
acceptance of, new interactive entertainment software platforms well in advance
of the time the platform is introduced to consumers. Because product development
cycles are difficult to predict, we must make substantial product development
and other investments in a particular platform well in advance of introduction
of the platform. If the platforms for which we develop new software products or
modify existing products are not released on a timely basis or do not attain
significant market penetration, or if we develop products for a delayed or
unsuccessful platform, our business and financial results could suffer material
harm.
New interactive entertainment software platforms and technologies also may
undermine demand for products based on older technologies. Our success will
depend in part on our ability to adapt our products to those emerging game
platforms that gain widespread consumer acceptance. Our business and financial
results may suffer material harm if we fail to:
o anticipate future technologies and platforms and the rate of market
penetration of those technologies and platforms;
o obtain licenses to develop products for those platforms on favorable
terms; or
o create software for those new platforms on a timely basis.
WE COMPETE WITH A NUMBER OF COMPANIES THAT HAVE SUBSTANTIALLY GREATER FINANCIAL,
MARKETING AND PRODUCT DEVELOPMENT RESOURCES THAN WE DO.
The greater resources of our competitors permit them to pay higher fees
than we can to licensors of desirable motion picture, television, sports and
character properties and to third party software developers.
We compete primarily with other publishers of personal computer and video
game console interactive entertainment software. Significant competitors include
Electronic Arts Inc. and Activision, Inc. Many of these competitors have
substantially greater financial, technical resources, larger customer bases,
longer operating histories, greater name recognition and more established
relationships in the industry than we do.
In addition, integrated video game console hardware/software companies such
as Sony Computer Entertainment, Nintendo, and Microsoft Corporation compete
directly with us in the development of software titles for their respective
platforms and they have generally discretionary approval authority over the
products we develop for their platforms. Large diversified entertainment
companies, such as The Walt Disney Company, many of which own substantial
libraries of available content and have substantially greater financial
resources, may decide to compete directly with us or to enter into exclusive
relationships with our competitors. We also believe that the overall growth in
the use of the Internet and online services by consumers may pose a competitive
threat if customers and potential customers spend less of their available home
personal computing time using interactive entertainment software and more time
using the Internet and online services.
OUR CUSTOMERS HAVE THE ABILITY TO RETURN OUR PRODUCTS OR TO RECEIVE PRICING
CONCESSIONS AND SUCH RETURNS AND CONCESSIONS COULD REDUCE OUR NET REVENUES AND
RESULTS OF OPERATIONS.
We are exposed to the risk of product returns and pricing concessions with
respect to our distributors and retailers. We allow distributors and retailers
to return defective, shelf-worn and damaged products in accordance with
negotiated terms, and also offer a 90-day limited warranty to our end users that
our products will be free from manufacturing defects. In addition, we provide
pricing concessions to our customers to manage our customers' inventory levels
in the distribution channel. We could be forced to accept substantial product
returns and provide pricing concessions to maintain our relationships with
retailers and our access to distribution channels. Product return and pricing
concessions that exceed our reserves have caused material harm to our results of
operations in the recent past and may do so again in the future. We have
mitigated this risk in North America under the new distribution arrangement with
Vivendi, as sales will be guaranteed with no offset against returns.
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SUBSTANTIAL SALES OF OUR COMMON STOCK BY OUR EXISTING STOCKHOLDERS MAY REDUCE
THE PRICE OF OUR STOCK AND DILUTE EXISTING STOCKHOLDERS.
We currently have effective registration statements covering a total of
approximately 53 million shares of our common stock for the benefit of those
shareholders. These shares are now eligible for immediate resale in the public
market. Included in these registrations were shares of common stock owned by
Universal Studios, Inc. (now owned by Vivendi), which beneficially owns
approximately 5 percent of our common stock, Titus Interactive S.A., which
beneficially owns approximately 72 percent of our common stock, and investors
that acquired shares of common stock in our April 2001 financing.
Future sales of common stock by these holders could substantially increase
the volume of shares being publicly traded and could decrease the trading price
of our common stock and, therefore, the price at which you could resell your
shares. A lower market price for our shares also might impair our ability to
raise additional capital through the sale of our equity securities. Any future
sales of our stock would also dilute existing stockholders.
WE DEPEND UPON THIRD PARTY LICENSES OF CONTENT FOR MANY OF OUR PRODUCTS.
Many of our current and planned products, such as our Star Trek, Advanced
Dungeons and Dragons and Caesars Palace titles, are lines based on original
ideas or intellectual properties licensed from other parties. From time to time
we may not be in compliance with certain terms of these license agreements, and
our ability to market products based on these licenses may be negatively
impacted. Moreover, disputes regarding these license agreements may also
negatively impact our ability to market products based on these licenses.
Additionally, we may not be able to obtain new licenses, or maintain or renew
existing licenses, on commercially reasonable terms, if at all. If we are unable
to maintain current licenses or obtain new licenses for the underlying content
that we believe offers the greatest consumer appeal, we would either have to
seek alternative, potentially less appealing licenses, or release products
without the desired underlying content, either of which could limit our
commercial success and cause material harm to our business.
WE MAY FAIL TO MAINTAIN EXISTING LICENSES, OR OBTAIN NEW LICENSES FROM HARDWARE
COMPANIES ON ACCEPTABLE TERMS OR TO OBTAIN RENEWALS OF EXISTING OR FUTURE
LICENSES FROM LICENSORS.
We are required to obtain a license to develop and distribute software for
each of the video game console platforms for which we develop products,
including a separate license for each of North America, Japan and Europe. We
have obtained licenses to develop software for the Sony PlayStation and
PlayStation 2, as well as video game platforms from Nintendo and Microsoft. In
addition, each of these companies has the right to approve the technical
functionality and content of our products for their platforms prior to
distribution. Due to the competitive nature of the approval process, we must
make significant product development expenditures on a particular product prior
to the time we seek these approvals. Our inability to obtain these approvals
could cause material harm to our business.
OUR SALES VOLUME AND THE SUCCESS OF OUR PRODUCTS DEPEND IN PART UPON THE NUMBER
OF PRODUCT TITLES DISTRIBUTED BY HARDWARE COMPANIES FOR USE WITH THEIR VIDEO
GAME PLATFORMS.
Even after we have obtained licenses to develop and distribute software, we
depend upon hardware companies such as Sony Computer Entertainment, Nintendo and
Microsoft, or their designated licensees, to manufacture the CD-ROM or DVD-ROM
media discs that contain our software. These discs are then run on the
companies' video game consoles. This process subjects us to the following risks:
o we are required to submit and pay for minimum numbers of discs we want
produced containing our software, regardless of whether these discs
are sold, shifting onto us the financial risk associated with poor
sales of the software developed by us; and
o reorders of discs are expensive, reducing the gross margin we receive
from software releases that have stronger sales than initially
anticipated and that require the production of additional discs.
As a result, video game console hardware licensors can shift onto us the
risk that if actual retailer and consumer demand for our interactive
entertainment software differs from our forecasts, we must either bear the loss
from
32
overproduction or the lower per-unit revenues associated with producing
additional discs. Either situation could lead to material reductions in our net
revenues.
WE HAVE A LIMITED NUMBER OF KEY PERSONNEL. THE LOSS OF ANY SINGLE KEY PERSON OR
THE FAILURE TO HIRE AND INTEGRATE CAPABLE NEW KEY PERSONNEL COULD HARM OUR
BUSINESS.
Our interactive entertainment software requires extensive time and creative
effort to produce and market. The production of this software is closely tied to
the continued service of our key product design, development, sales, marketing
and management personnel. Our future success also will depend upon our ability
to attract, motivate and retain qualified employees and contractors,
particularly software design and development personnel. Competition for highly
skilled employees is intense, and we may fail to attract and retain such
personnel. Alternatively, we may incur increased costs in order to attract and
retain skilled employees. Our failure to retain the services of key personnel,
including competent executive management, or to attract and retain additional
qualified employees could cause material harm to our business.
OUR INTERNATIONAL SALES EXPOSE US TO RISKS OF UNSTABLE FOREIGN ECONOMIES,
DIFFICULTIES IN COLLECTION OF REVENUES, INCREASED COSTS OF ADMINISTERING
INTERNATIONAL BUSINESS TRANSACTIONS AND FLUCTUATIONS IN EXCHANGE RATES.
Our net revenues from international sales accounted for approximately 12
percent and 17 percent of our total net revenues for the six months ended June
30 2002 and 2001, respectively. Most of these revenues come from our
distribution relationship with Virgin, pursuant to which Virgin became the
exclusive distributor for most of our products in Europe, the Commonwealth of
Independent States, Africa and the Middle East. To the extent our resources
allow, we intend to continue to expand our direct and indirect sales, marketing
and product localization activities worldwide.
Our international sales and operations are subject to a number of inherent
risks, including the following:
o recessions in foreign economies may reduce purchases of our products;
o translating and localizing products for international markets is time-
consuming and expensive;
o accounts receivable are more difficult to collect and when they are
collectible, they may take longer to collect;
o regulatory requirements may change unexpectedly;
o it is difficult and costly to staff and manage foreign operations;
o fluctuations in foreign currency exchange rates;
o political and economic instability;
o our dependence on Virgin as our exclusive distributor in Europe, the
Commonwealth of Independent States, Africa and the Middle East; and
o delays in market penetration of new platforms in foreign territories.
These factors may cause material declines in our future international net
revenues and, consequently, could cause material harm to our business.
A significant, continuing risk we face from our international sales and
operations stems from currency exchange rate fluctuations. Because we do not
engage in currency hedging activities, fluctuations in currency exchange rates
have caused significant reductions in our net revenues from international sales
and licensing due to the loss in value upon conversion into U.S. Dollars. We may
suffer similar losses in the future.
INADEQUATE INTELLECTUAL PROPERTY PROTECTIONS COULD PREVENT US FROM ENFORCING OR
DEFENDING OUR PROPRIETARY TECHNOLOGY.
We regard our software as proprietary and rely on a combination of patent,
copyright, trademark and trade secret laws, employee and third party
nondisclosure agreements and other methods to protect our proprietary rights. We
own or license various copyrights and trademarks, and hold the rights to one
patent application related to one of our titles. While we provide "shrinkwrap"
license agreements or limitations on use with our software, it is uncertain to
33
what extent these agreements and limitations are enforceable. We are aware that
some unauthorized copying occurs within the computer software industry, and if a
significantly greater amount of unauthorized copying of our interactive
entertainment software products were to occur, it could cause material harm to
our business and financial results.
Policing unauthorized use of our products is difficult, and software piracy
can be a persistent problem, especially in some international markets. Further,
the laws of some countries where our products are or may be distributed either
do not protect our products and intellectual property rights to the same extent
as the laws of the United States, or are weakly enforced. Legal protection of
our rights may be ineffective in such countries, and as we leverage our software
products using emerging technologies such as the Internet and online services,
our ability to protect our intellectual property rights and to avoid infringing
others' intellectual property rights may diminish. We cannot assure you that
existing intellectual property laws will provide adequate protection for our
products in connection with these emerging technologies.
WE MAY UNINTENTIONALLY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS,
WHICH COULD EXPOSE US TO SUBSTANTIAL DAMAGES OR RESTRICT OUR OPERATIONS.
As the number of interactive entertainment software products increases and
the features and content of these products continue to overlap, software
developers increasingly may become subject to infringement claims. Although we
believe that we make reasonable efforts to ensure that our products do not
violate the intellectual property rights of others, it is possible that third
parties still may claim infringement. From time to time, we receive
communications from third parties regarding such claims. Existing or future
infringement claims against us, whether valid or not, may be time consuming and
expensive to defend. Intellectual property litigation or claims could force us
to do one or more of the following:
o cease selling, incorporating or using products or services that
incorporate the challenged intellectual property;
o obtain a license from the holder of the infringed intellectual
property, which license, if available at all, may not be available on
commercially favorable terms; or
o redesign our interactive entertainment software products, possibly in
a manner that reduces their commercial appeal.
Any of these actions may cause material harm to our business and financial
results.
OUR SOFTWARE MAY BE SUBJECT TO GOVERNMENTAL RESTRICTIONS OR RATING SYSTEMS.
Legislation is periodically introduced at the state and federal levels in
the United States and in foreign countries to establish a system for providing
consumers with information about graphic violence and sexually explicit material
contained in interactive entertainment software products. In addition, many
foreign countries have laws that permit governmental entities to censor the
content of interactive entertainment software. We believe that mandatory
government-run rating systems eventually will be adopted in many countries that
are significant markets or potential markets for our products. We may be
required to modify our products to comply with new regulations, which could
delay the release of our products in those countries.
Due to the uncertainties regarding such rating systems, confusion in the
marketplace may occur, and we are unable to predict what effect, if any, such
rating systems would have on our business. In addition to such regulations,
certain retailers have in the past declined to stock some of our products
because they believed that the content of the packaging artwork or the products
would be offensive to the retailer's customer base. While to date these actions
have not caused material harm to our business, we cannot assure you that similar
actions by our distributors or retailers in the future would not cause material
harm to our business.
34
SOME PROVISIONS OF OUR CHARTER DOCUMENTS MAY MAKE TAKEOVER ATTEMPTS DIFFICULT,
WHICH COULD DEPRESS THE PRICE OF OUR STOCK AND INHIBIT OUR ABILITY TO RECEIVE A
PREMIUM PRICE FOR YOUR SHARES.
Our Board of Directors has the authority, without any action by the
stockholders, to issue up to 5,000,000 shares of preferred stock and to fix the
rights and preferences of such shares. In addition, our certificate of
incorporation and bylaws contain provisions that:
o eliminate the ability of stockholders to act by written consent and to
call a special meeting of stockholders; and
o require stockholders to give advance notice if they wish to nominate
directors or submit proposals for stockholder approval.
These provisions may have the effect of delaying, deferring or preventing a
change in control, may discourage bids for our common stock at a premium over
its market price and may adversely affect the market price, and the voting and
other rights of the holders, of our common stock.
OUR STOCK PRICE IS VOLATILE.
The trading price of our common stock has previously fluctuated and could
continue to fluctuate in response to factors that are largely beyond our
control, and which may not be directly related to the actual operating
performance of our business, including:
o general conditions in the computer, software, entertainment, media or
electronics industries;
o changes in earnings estimates or buy/sell recommendations by analysts;
o investor perceptions and expectations regarding our products, plans
and strategic position and those of our competitors and customers; and
o price and trading volume volatility of the broader public markets,
particularly the high technology sections of the market.
WE DO NOT PAY DIVIDENDS ON OUR COMMON STOCK.
We have not paid any cash dividends on our common stock and do not
anticipate paying dividends in the foreseeable future.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not have any derivative financial instruments as of June 30, 2002.
However, we are exposed to certain market risks arising from transactions in the
normal course of business, principally the risk associated with foreign currency
fluctuations. We do not hedge our risk associated with foreign currency
fluctuations.
Interest Rate Risk
Our interest rate risk is due to our working capital lines of credit
typically having an interest rate based on either the bank's prime rate or
LIBOR. Currently, we do not have a line of credit, but we anticipate
establishing a line of credit in the future. With the consummation of the Shiny
sale on April 30, 2002 we retired all of our outstanding interest bearing debt
and provided a note payable with an interest rate of 6 percent per annum due in
2003 to a party to the transaction.
Foreign Currency Risk
Our earnings are affected by fluctuations in the value of our foreign
subsidiary's functional currency, and by fluctuations in the value of the
functional currency of our foreign receivables, primarily from Virgin. We
recognized foreign exchange gains of $68,000 and losses of $339,000 during the
six months ended June 30, 2002 and 2001,
35
respectively, primarily in connection with foreign exchange fluctuations in the
timing of payments received on accounts receivable from Virgin.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Company is involved in various legal proceedings, claims and litigation
arising in the ordinary course of business, including disputes arising over the
ownership of intellectual property rights and collection matters. In the opinion
of management, the outcome of known routine claims will not have a material
adverse effect on the Company's business, financial condition or results of
operations.
On January 15, 2002, Rage Games Limited ("Rage") filed a breach of contract
action against the Company relating to the August 3, 2000 North American
distribution agreement and the February 9, 2001 OEM distribution agreement. In
the complaint, Rage alleged that the Company failed to make royalty payments
under these agreements. Rage sought damages in the amount of $2.9 million plus
interest and punitive damages. Furthermore, Rage sought to audit the Company's
books, return all of Rage's software and a cease & desist of all manufacturing &
further distribution of Rage's software. The Company`s settlement for all claims
with Rage in April 2002 included payment terms on the settlement amount of $1.3
million. If payments are not made under the terms of the settlement, then Rage
may enter into a stipulation judgment for the full amount of the claim.
Item 5. Other Information
On August 14, 2002, the Company received a Nasdaq Staff Determination
letter indicating that the Company failed to regain compliance with the minimum
$1.00 bid price per share requirement for continued listing on The Nasdaq
SmallCap Market set forth in Marketplace Rule 4310(c)(8)(D). Pursuant to an
earlier grace period granted by Nasdaq, the Company had until August 13, 2002 to
regain compliance with the minimum bid price per share requirement.
Nasdaq informed the Company that its securities will be delisted from The
Nasdaq SmallCap Market at the opening of business on August 22, 2002, unless the
Company appeals the Staff's determination. The Company has requested an appeal
hearing before a Nasdaq Listing Qualifications Panel to review the Staff's
determination. The hearing request will stay the delisting of the Company's
securities pending the Panel's decision. There can be no assurance, however,
that the Panel will grant the Company's request for continued listing.
A copy of the press release dated August 15, 2002, issued by the Company in
connection with the Nasdaq Stock Market notification, is attached as Exhibit
99.2 to this Form 10-Q, and is incorporated herein by reference.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits - The following exhibits are filed as part of this report:
Exhibit Number Exhibit Title
-------------- -------------
99.1 Management's certification of financial statements.
99.2 Press Release, dated August 15, 2002.
36
(b) Reports on Form 8-K
The Company filed a Current Report on Form 8-K on April 10, 2002,
that Titus Interactive SA, the Company's majority stockholder,
converted its remaining shares of Series A Preferred Stock into
common stock.
The Company filed a Current Report on Form 8-K on April 29, 2002,
reporting that the Company and Infogrames, Inc. had entered into an
agreement for the sale of the Company's Shiny Entertainment, Inc.
subsidiary.
The Company filed a Current Report on Form 8-K on May 6, 2002,
reporting that the Company consummated the sale of its majority owned
subsidiary, Shiny Entertainment, Inc. to Infogrames, Inc.
The Company filed a Current Report on Form 8-K/A on May 15, 2002,
which amended the Current Report on Form 8-K filed by the Company on
May 6, 2002, reporting that the Company consummated the sale of its
majority owned subsidiary, Shiny Entertainment, Inc. to Infogrames,
Inc.
37
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
INTERPLAY ENTERTAINMENT CORP.
Date: August 19, 2002 By: /s/ HERVE CAEN
-----------------------------------
Herve Caen,
President
(Principal Executive Officer)
Date: August 19, 2002 By: /s/ Jeff Gonzalez
-----------------------------------
Jeff Gonzalez
Chief Financial Officer
(Principal Financial and Accounting
Officer)
38