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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended June 30, 2003
or
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________ to ________
Commission file number: 000-22023
MACROVISION CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 77-0156161
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
2830 De La Cruz Boulevard, Santa Clara, CA 95050
(Address of principal executive offices) (Zip Code)
(408) 743-8600
(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 by check mark whether the registrant is an accelerated filer (as
defined by Rule 12b-2 of the Exchange Act).
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 Outstanding as of August 1, 2003
Common stock, $0.001 par value 48,740,670
MACROVISION CORPORATION
FORM 10-Q
INDEX
PART I - FINANCIAL INFORMATION
Page
Item 1. Financial Statements.
Condensed Consolidated Balance Sheets as of June 30, 2003
and December 31, 2002. 1
Condensed Consolidated Statements of Income
for the Three and Six Month Periods Ended June 30, 2003 and 2002. 2
Condensed Consolidated Statements of Cash Flows
for the Six Months Ended June 30, 2003 and 2002. 3
Notes to Condensed Consolidated Financial Statements. 4
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations. 16
Item 3. Quantitative and Qualitative Disclosures about Market Risk. 29
Item 4. Controls and Procedures. 30
PART II - OTHER INFORMATION
Item 1. Legal Proceedings. 31
Item 2. Changes in Securities and Use of Proceeds. 33
Item 3. Defaults Upon Senior Securities. 33
Item 4. Submission of Matters to a Vote of Security Holders. 33
Item 5. Other Information. 34
Item 6. Exhibits and Reports on Form 8-K. 34
Signatures 35
i
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MACROVISION CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
(UNAUDITED)
JUNE 30, DECEMBER 31,
2003 2002
-------------------- -------------------
ASSETS
Current assets:
Cash and cash equivalents $ 36,535 $ 98,691
Short-term investments 110,682 72,989
Accounts receivable, net of allowance for doubtful accounts of
$1,612 and $1,657, respectively 23,247 28,237
Income taxes receivable 9,833 9,242
Deferred tax assets 4,778 4,695
Prepaid expenses and other current assets 4,696 5,367
-------------------- -------------------
Total current assets 189,771 219,221
Long-term marketable investment securities 99,306 38,696
Property and equipment, net 5,885 6,106
Patents, net 10,359 4,593
Goodwill 26,101 24,673
Other intangibles from acquisitions, net 9,530 11,368
Deferred tax assets 10,369 13,971
Other assets 1,194 6,038
-------------------- -------------------
$ 352,515 $ 324,666
==================== ===================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,938 $ 3,269
Deferred revenue 11,163 8,567
Other current liabilities 17,199 15,523
-------------------- -------------------
Total current liabilities 32,300 27,359
Notes payable 17 17
Other non current liabilities 802 431
-------------------- -------------------
Total Liabilities 33,119 27,807
Stockholders' equity:
Common stock 52 51
Treasury stock, at cost (38,450) (38,450)
Additional paid-in-capital 287,090 284,031
Deferred stock-based compensation (1,468) (3,024)
Accumulated other comprehensive income 8,318 1,933
Retained earnings 63,854 52,318
-------------------- -------------------
Total stockholders' equity 319,396 296,859
-------------------- -------------------
$ 352,515 $ 324,666
==================== ===================
See the accompanying notes to these condensed consolidated financial statements.
1
MACROVISION CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------------ ------------------------------------
2003 2002 2003 2002
----------------- ----------------- ----------------- -----------------
Revenues:
Licenses $ 26,223 $ 22,383 $ 51,465 $ 43,594
Services 2,989 2,557 5,799 5,012
----------------- ----------------- ----------------- -----------------
Total revenues 29,212 24,940 57,264 48,606
Cost of revenues:
License fees 1,183 1,523 2,122 2,688
Service fees 597 365 1,140 863
Amortization of intangibles from acquisitions 856 540 1,712 1,080
----------------- ----------------- ----------------- -----------------
Total cost of revenues 2,636 2,428 4,974 4,631
----------------- ----------------- ----------------- -----------------
Gross profit 26,576 22,512 52,290 43,975
Operating expenses:
Research and development 4,156 2,832 7,899 5,369
Selling and marketing 6,472 4,582 12,876 9,342
General and administrative 4,648 3,618 8,972 6,666
Amortization of intangibles from acquisitions - 149 - 298
Amortization of deferred stock-based compensation* 752 2,041 1,520 4,124
----------------- ----------------- ----------------- -----------------
Total operating expenses 16,028 13,222 31,267 25,799
----------------- ----------------- ----------------- -----------------
Operating income 10,548 9,290 21,023 18,176
Impairment losses on investments, net (3,850) - (3,850) (5,477)
Interest and other income, net 953 2,067 2,053 4,168
----------------- ----------------- ----------------- -----------------
Income before income taxes 7,651 11,357 19,226 16,867
Income taxes 3,060 4,770 7,690 7,306
----------------- ----------------- ----------------- -----------------
Net income $ 4,591 $ 6,587 $ 11,536 $ 9,561
================= ================= ================= =================
Basic net earnings per share $ 0.09 $ 0.13 $ 0.24 $ 0.19
================= ================= ================= =================
Shares used in computing basic net earnings per share 48,619 51,120 48,566 51,046
================= ================= ================= =================
Diluted net earnings per share $ 0.09 $ 0.13 $ 0.24 $ 0.19
================= ================= ================= =================
Shares used in computing diluted net earnings per share 49,299 51,340 49,038 51,500
================= ================= ================= =================
* The allocation of the amortization of deferred stock-based compensation relates to the expense categories as set forth below:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------------ ------------------------------------
2003 2002 2003 2002
----------------- ----------------- ----------------- -----------------
Cost of revenues $ 80 $ 117 $ 160 $ 234
Research and development 138 403 277 847
Selling and marketing 331 1,257 677 2,514
General and administrative 203 264 406 529
----------------- ----------------- ----------------- -----------------
$ 752 $ 2,041 $ 1,520 $ 4,124
================= ================= ================= =================
See the accompanying notes to these condensed consolidated financial statements.
2
MACROVISION CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
----------------------------------------------
2003 2002
---------------------- --------------------
Cash flows from operating activities:
Net income $ 11,536 $ 9,561
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 1,390 1,301
Amortization of intangibles from acquisitions 1,712 1,378
Amortization of deferred stock-based compensation 1,520 4,124
Tax benefit from stock options 591 1,078
Impairment losses on investments, net 3,850 5,477
Changes in operating assets and liabilities:
Accounts receivable, net 5,079 2,912
Deferred revenue 2,568 133
Other assets 2,562 7,722
Other liabilities 809 500
---------------------- --------------------
Net cash provided by operating activities 31,617 34,186
Cash flows from investing activities:
Purchases of long-term marketable investment securities (66,530) -
Sales or maturities of long-term marketable investment
securities 14,713 38,493
Purchases of short-term investments (151,875) (81,835)
Sales or maturities of short-term investments 113,986 75,463
Acquisition of property and equipment (751) (2,878)
Acquisition of TTR assets and patents (5,050) -
Other investing activities (978) (423)
---------------------- --------------------
Net cash (used in) provided by investing activities (96,485) 28,820
Cash flows from financing activities:
Proceeds from issuance of common stock from options and
stock purchase plans 2,491 2,556
Treasury stock acquisitions - (3,398)
---------------------- --------------------
Net cash provided by (used in) financing activities 2,491 (842)
Effect of exchange rate changes on cash and cash equivalents 221 77
---------------------- --------------------
Net (decrease) increase in cash and cash equivalents (62,156) 62,241
Cash and cash equivalents at beginning of period 98,691 26,112
---------------------- --------------------
Cash and cash equivalents at end of period $ 36,535 $ 88,353
====================== ====================
Supplemental cash flow information:
Income taxes paid $ 5,464 $ 2,000
TTR common stock surrendered in exchange for patents $ 602 $ -
See the accompanying notes to these condensed consolidated financial statements.
3
MACROVISION CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1
BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared by Macrovision Corporation and its subsidiaries (the "Company") in
accordance with the rules and regulations of the Securities and Exchange
Commission. Certain information and footnote disclosures, normally included in
financial statements prepared in accordance with accounting principles generally
accepted in the United States of America, have been condensed or omitted in
accordance with such rules and regulations. However, the Company believes the
disclosures are adequate to make the information not misleading. In the opinion
of management, the accompanying unaudited condensed consolidated financial
statements reflect all adjustments, consisting only of normal recurring
adjustments, except as described in Notes 4 and 5, which in the opinion of
management are considered necessary to present fairly the results for the
periods presented. This quarterly report on Form 10-Q should be read in
conjunction with the audited financial statements and notes thereto and other
disclosures, including those items disclosed under the caption "Risk Factors,"
contained in the Company's Annual Report on Form 10-K for the year ended
December 31, 2002.
The consolidated results of operations for the interim periods presented
are not necessarily indicative of the results expected for the entire year
ending December 31, 2003 or any other future interim period.
Certain prior period amounts have been reclassified on the June 30, 2002
condensed consolidated statements of income to conform to the current period
presentation.
STOCK BASED COMPENSATION
The Company accounts for employee stock-based compensation arrangements in
accordance with the provisions of Accounting Principles Board ("APB") Opinion
No. 25, "Accounting for Stock Issued to Employees," Financial Accounting
Standards Board ("FASB") Interpretation No. 44 ("FIN 44"), "Accounting for
Certain Transactions Involving Stock Compensation - an Interpretation of APB
Opinion No. 25," and complies with the disclosure provisions of Statement of
Financial Accounting Standard ("SFAS") No. 123, "Accounting for Stock-Based
Compensation." The Company accounts for equity instruments issued to
non-employees in accordance with the provisions of SFAS No. 123 and Emerging
Issues Task Force ("EITF") No. 96-18, "Accounting for Equity Instruments That
Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services."
4
If compensation cost for the Company's stock-based compensation plans had
been determined in a manner consistent with the fair value approach described in
SFAS No. 123, the Company's net income and net income per share as reported
would have been reduced to the pro forma amounts indicated below (in thousands,
except per share data):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------ ------------------------------
2003 2002 2003 2002
-------------- -------------- --------------- -------------
Net income, as reported $ 4,591 $ 6,587 $ 11,536 $ 9,561
Add stock-based employee compensation
expense included in reported net
income, net of tax 451 1,184 912 2,351
Deduct total stock-based employee
compensation expenses determined under
fair-value-based method for all
rewards, net of related tax effects (6,550) (10,618) (14,304) (22,034)
-------------- -------------- --------------- -------------
Net loss, pro forma $ (1,508) $ (2,847) $ (1,856) $ (10,122)
============== ============== =============== =============
Basic net income (loss) per share As reported $ 0.09 $ 0.13 $ 0.24 $ 0.19
Adjusted pro forma $ (0.03) $ (0.06) $ (0.04) $ (0.20)
Diluted net income (loss) per share As reported $ 0.09 $ 0.13 $ 0.24 $ 0.19
Adjusted pro forma $ (0.03) $ (0.06) $ (0.04) $ (0.20)
Options vest over several years and new options are generally granted each
year. Because of these factors, the pro forma effect shown above may not be
representative of the pro forma effect of SFAS No. 123 in future years.
The fair value of each option is estimated on the date of grant using the
Black-Scholes method with the following weighted average assumptions for the
Option Plans and the ESPP Plan:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------------- ---------------------------------
2003 2002 2003 2002
--------------- -------------- --------------- ---------------
OPTION PLANS:
Dividends None None None None
Expected term 2.83 years 3.24 years 3.20 years 3.25 years
Risk free interest rate 4.36% 4.91% 3.89% 4.85%
Volatility rate 75.4% 73.5% 76.9% 73.5%
ESPP PLAN:
Dividends None None None None
Expected term 1.5 years 1.38 years 1.33 years 1.33 years
Risk free interest rate 2.71% 4.30% 2.81% 4.53%
Volatility rate 75.2% 81.8% 75.8% 83.5%
The weighted average fair value of options granted during the three months
ended June 30, 2003 and 2002 was $8.81 and $11.78, respectively. The weighted
average fair value of options granted during the six months ended June 30, 2003
and 2002 was $7.13 and $12.10, respectively. The weighted average fair value
5
of an ESPP share purchase right during the three months ended June 30, 2003 and
2002 were $7.16 and $21.34, respectively. The weighted average fair value of an
ESPP share purchase right during the six months ended June 30, 2003 and 2002
were $7.81 and $22.60, respectively.
NOTE 2 - REVENUE RECOGNITION
The Company's revenue primarily consists of royalty fees on copy-protected
products on a per unit basis, licenses of the Company's copy protection
technology, licenses for the Company's ELM (electronic license management) and
DRM (digital rights management) software products, and related maintenance and
services revenues.
ROYALTY REVENUES
Royalty revenue from the replication of copy protected videocassettes,
digital versatile discs ("DVDs"), and compact disks ("CDs") is recognized when
realized or realizable and earned. We rely on royalty reports from third parties
as our basis for revenue recognition. In our DVD, videocassette, and consumer
software copy protection businesses, the Company has established significant
experience with certain customers to reasonably estimate current period volume
for purposes of making an accurate revenue accrual. Accordingly, royalty revenue
from these customers is recognized as earned. Revenue from customers in our
pay-per-view ("PPV") and Music Technology Division is currently recognized only
as reported, due to the timing of receipt of reports in PPV, and the embryonic
stage and volume volatility of the audio market. Advanced royalty fees
attributable to minimum copy quantities or shared revenues are deferred until
earned. In the case of agreements with minimum guaranteed royalty payments with
no specified volume, revenue is recognized on a straight-line basis over the
life of the agreement.
TECHNOLOGY LICENSING REVENUES
Technology licensing revenue, which applies principally to DVD and PC
subassembly manufacturers, digital PPV, cable and satellite system operators,
and set-top decoder manufacturers, is recognized upon establishment of
persuasive evidence of an arrangement, performance of all significant
obligations and determination that collection of a fixed or determinable license
fee is considered probable.
SOFTWARE LICENSING REVENUES
The Company recognizes revenue on its software products in accordance with
Statement of Position ("SOP") 97-2, "Software Revenue Recognition," as amended
by SOP 98-9 "Modification of SOP 97-2." The Company recognizes revenue when all
of the following criteria are met: persuasive evidence of an arrangement exists;
delivery of the product has occurred; no significant obligations by the Company
remain; the fee is fixed or determinable; and collectibility is probable. The
Company considers all arrangements with payment terms extending beyond six
months to not be fixed or determinable, and, accordingly, revenue is recognized
as amounts under such arrangements become due and payable. The Company assesses
collectibility based on a number of factors, including the customer's past
payment history and current creditworthiness. If collectibility is not
considered probable, revenue is recognized when the fee is collected from the
customer.
For license agreements in which non-standard customer acceptance clauses
are a condition to earning the license fees, revenue is not recognized until
acceptance occurs. For arrangements containing multiple elements, such as
software license fees, consulting services and maintenance, or multiple products
and where vendor-specific objective evidence of fair value ("VSOE") exists for
all undelivered elements, the Company accounts for the delivered elements in
accordance with the "residual method." Under the residual method, the fair value
of the undelivered elements is deferred and the remaining
6
portion of the arrangement fee is recognized as revenue. For arrangements
containing multiple elements where VSOE does not exist, all revenue is deferred
until such time that VSOE is evidenced or all elements of the arrangement have
been delivered, or if the only undelivered element is maintenance, revenue is
recognized ratably over the maintenance contract period. The Company also enters
into term license agreements in which the license fee is recognized ratably over
the term of the license period (generally one year).
When licenses are sold together with consulting and implementation
services, license fees are recognized upon delivery provided that (1) the above
criteria have been met, (2) payment of the license fees is not dependent upon
performance of the consulting and implementation services, and (3) the services
are not essential to the functionality of the software. For arrangements where
the services are essential to the functionality of the software, both the
license and services revenue are recognized in accordance with the provisions of
SOP 81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts." Arrangements that allow the Company to make
reasonably dependable estimates relative to contract costs and the extent of
progress toward completion are accounted for using the percentage-of-completion
method. Arrangements that do not allow the Company to make reasonably dependable
estimates are accounted for using the completed-contracts-method.
PROFESSIONAL SERVICES REVENUES
The Company provides consulting and training services to its customers.
Revenue from such services is generally recognized as the services are
performed, except in situations where services are included in an arrangement
accounted for under SOP 81-1. Professional services revenues are included in
services revenue in the accompanying condensed consolidated financial
statements.
MAINTENANCE REVENUES
Maintenance agreements generally call for the Company to provide technical
support and software updates to customers. Maintenance revenue is deferred and
recognized ratably over the maintenance contract period (which is generally one
year) and included in services revenue in the accompanying condensed
consolidated financial statements.
NOTE 3 - ASSET PURCHASE
In May 2003, the Company acquired patents and other assets of TTR
Technologies, Inc. ("TTR") for $5.1 million in cash and the surrender of
1,880,937 shares of TTR common stock, with a fair value of $602,000 that the
Company originally purchased in January 2000. The total purchase price of $5.7
million has been allocated to patents and other intangibles. The Company
recorded a realized gain of $395,000 for the excess of the market value of such
TTR stock on the closing date of the acquisition over the adjusted cost basis of
such stock. This gain has been included in "Impairment losses on investments,
net" in the accompanying condensed consolidated financial statements.
NOTE 4 - INVESTMENTS IN MARKETABLE SECURITIES
The Company accounts for its publicly traded investments in accordance with
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities." Management determines the appropriate classification of investment
securities at the time of purchase and re-evaluates such designation as of each
balance sheet date. The Company enters into certain equity investments for the
promotion of business and strategic objectives, and typically does not attempt
to reduce or eliminate the
7
inherent market risks associated with these investments. As of June 30, 2003 and
December 31, 2002, all marketable investment securities were designated as
"available-for-sale." Available-for-sale securities are carried at fair value
based on quoted market prices, with unrealized gains and losses reported in
accumulated other comprehensive income (loss) as a separate component of
stockholders' equity.
All marketable debt securities with remaining maturities over one year or
which the Company's intent is to retain its investment for the long-term are
classified as long-term marketable investment securities.
Realized losses and declines in value judged to be other-than-temporary for
available-for-sale securities are reported as non-operating expenses under the
caption "Impairment losses on investments, net." The Company performs regular
reviews, in accordance with Company policy, of the value of its public company
strategic investments. The cost of securities sold is based on the specific
identification method. Interest and dividends on securities classified as
available-for-sale are included in other income.
During the first quarter of 2002, the Company recorded charges of $2.5
million from other than temporary declines in the fair value of long-term
marketable securities in public companies. This was in addition to a charge of
$3.0 million during the six months ended June 30, 2002 from impairment charges
related to investments in non-public companies (see Note 5).
During the three and six months ended June 30, 2003, the Company recorded a
realized gain of $395,000 from the surrender of the Company's stock in TTR, a
public company strategic investment (see Note 3). This realized gain was
separate from and offset by a charge of $4.3 million during the three and six
months ended June 30, 2003 from impairment charges related to investments in
non-public companies (see Note 5). There were no charges related to
other-than-temporary declines in the fair value of long-term marketable
securities for the periods ended June 30, 2003.
NOTE 5 - OTHER ASSETS
The Company has made certain strategic investments that it intends to hold
for the long-term and monitors whether there has been a decline in value that is
considered other-than-temporary. The Company reviews its investments in
non-public companies and estimates the amount of any other-than-temporary
impairment incurred during the current period based on specific analysis of each
investment, considering the activities of and events occurring at each of the
underlying portfolio companies during the period. The Company's portfolio
companies operate in industries that are rapidly evolving and extremely
competitive. For equity investments in non-public companies for which there is
no market where their value is readily determinable, each investment is reviewed
for indicators of impairment on a regular basis based primarily on achievement
of business plan objectives and current market conditions, among other factors.
The primary business plan objectives considered include, among others, those
related to financial performance such as liquidity, achievement of planned
financial results or completion of capital raising activities, and those that
are not primarily financial in nature such as the launching of technology or the
hiring of key employees. If it is determined that an other-than-temporary
impairment has occurred with respect to an investment in a portfolio company, in
the absence of quantitative valuation metrics, such as a recent financing round,
management estimates the impairment and/or the net realizable value of the
portfolio investment based on a hypothetical liquidation at book value approach
as of the reporting date. Future adverse changes in market conditions or poor
operating results of underlying investments could result in losses or an
inability to recover the current carrying value of the investments thereby
requiring further impairment charges in the future.
8
During the six months ended June 30, 2003 and 2002, the Company recorded
charges of $4.3 million and $3.0 million, respectively, relating to impairment
losses considered to be other-than-temporary declines in the value of certain
strategic long term investments in non-public companies.
NOTE 6 - EARNINGS PER SHARE
Basic earnings per share ("EPS") is computed using the weighted average
number of common shares outstanding during the period. Diluted EPS is computed
using the weighted average number of common and dilutive potential common shares
outstanding during the period except for periods of operating loss for which no
potential common shares are included because their effect would be
anti-dilutive. Dilutive potential common shares consist of common stock issuable
upon exercise of stock options using the treasury stock method. The following is
a reconciliation of the shares used in the computation of basic and diluted EPS
(in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------------- --------------------------------
2003 2002 2003 2002
-------------- -------------- -------------- --------------
Basic EPS - weighted average number of common
shares outstanding 48,619 51,120 48,566 51,046
Effect of dilutive potential common shares -
stock options outstanding 680 220 472 454
-------------- -------------- -------------- --------------
Diluted EPS - weighted average number of
common shares and dilutive potential
common shares outstanding 49,299 51,340 49,038 51,500
============== ============== ============== ==============
Anti-dilutive shares excluded 4,151 4,176 4,335 3,523
============== ============== ============== ==============
The anti-dilutive shares excluded from the diluted EPS calculation noted in
the above table represent stock options where the exercise price was greater
than the average market price for the periods presented.
NOTE 7 - OFFER TO EXCHANGE OUTSTANDING STOCK OPTIONS TO PURCHASE COMMON STOCK
On May 27, 2003, the Company's stockholders approved a program to permit
the exchange of stock options issued under the 2000 Equity Plan and the 1996
Equity Incentive Plan having an exercise price greater than $28.00 for a lesser
number of new options to be granted at least six months and one day from the
cancellation of the surrendered options (the "Option Exchange Program").
The Company plans on implementing the Option Exchange Program by filing a
Tender Offer Statement with the U.S. Securities and Exchange Commission in late
August 2003.
The Company has designed the Option Exchange Program so that the Company
will not need to record compensation expense from the issuance of new stock
options under current accounting principles.
9
NOTE 8 - TREASURY STOCK
In May 2002, the Board of Directors authorized a stock repurchase program
for up to 5.0 million shares of the Company's common stock. Purchases of the
stock may be made, from time-to-time, in the open market at prevailing market
prices, at the discretion of Company management and as monitored by the Audit
Committee of the Company's Board of Directors. The Company's repurchases of
shares of common stock have been recorded as treasury stock at cost and result
in a reduction of stockholders' equity. As of June 30, 2003, treasury stock
consisted of 3.0 million shares of common stock that the Company had
repurchased, with a cost basis of approximately $38.5 million. As of June 30,
2003, 2.0 million shares remained authorized for repurchase.
NOTE 9 - RECENT ACCOUNTING PRONOUNCEMENTS
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. This statement applies to
legal obligations associated with retirement of long-lived assets that result
from the acquisition, construction, development, or normal use of an asset. The
Company adopted the statement effective January 1, 2003 without material effect
on its financial position or results of operations.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 addresses financial
accounting and reporting for costs associated with exit or disposal activities
and supercedes EITF No. 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (Including Certain
Costs Incurred in a Restructuring)." This statement requires that a liability
for a cost associated with an exit or disposal activity be recognized when the
liability is incurred and establishes that fair value is the objective for
initial measurement of the liabilities. This statement is effective for exit or
disposal activities that are initiated after December 31, 2002. The Company
adopted the provisions of this statement effective January 1, 2003 without
material effect on its financial position or results of operations.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure - an amendment to FASB Statement No.
123, Accounting for Stock-Based Compensation." SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition, SFAS No. 148
amends the disclosure requirements of SFAS No.123 to require more prominent and
more frequent disclosures in financial statements about the effects of
stock-based compensation. The transition guidance and annual disclosure
provisions of SFAS No. 148 are effective for fiscal years ending after December
15, 2002. The interim disclosure provisions are effective for financial reports
containing financial statements for interim periods beginning after December 15,
2002. The Company did not adopt the fair value method of accounting for
stock-based compensation and thus is not affected by the provisions of this
Statement relating to methods of transition to the fair value method. The
Company has adopted the interim disclosure provisions for its interim financial
statements beginning with the period ending March 31, 2003.
In November 2002, the FASB issued FIN No. 45 ("FIN 45"), "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others." FIN 45 expands on the accounting guidance
of FASB Statements No. 5, 57, and 107 and incorporates without change the
provisions of FIN No. 34, which is being superseded. FIN 45 will affect leasing
transactions involving residual guarantees, vendor and manufacturer guarantees,
and tax and environmental indemnities. All such guarantees will need to be
disclosed in the notes to the financial
10
statements starting with the period ending after December 15, 2002. Existing
guarantees will be grandfathered and will not be recognized on the balance
sheet. The initial recognition and measurement provision are effective
prospectively for guarantees issued or modified on or after January 1, 2003. The
Company adopted the provisions of this statement effective January 1, 2003
without material effect on its financial position or results of operations.
In January 2003, the FASB issued FIN No. 46 ("FIN 46"), "Consolidation of
Variable Interest Entities - An Interpretation of Accounting Research Bulletin
No. 51." FIN 46 requires a variable interest entity to be consolidated by a
company if that company is subject to a majority of the risk of loss from the
variable interest entity's activities or is entitled to receive a majority of
the entity's residual returns or both. A variable interest entity is a
corporation, partnership, trust, or any other legal structure used for business
purposes that either: (a) does not have equity investors with voting rights, or
(b) has equity investors that do not provide sufficient financial resources for
the entity to support its activities. The consolidation requirements of FIN 46
apply immediately to variable interest entities created after January 31, 2003
or to entities in which an interest is acquired after January 31, 2003. The
consolidation requirements of FIN 46 apply to older entities in the first fiscal
year or interim period beginning after June 15, 2003. Disclosure requirements
apply to any financial statements issued after January 31, 2003. The Company had
no investments in variable interest entities as of June 30, 2003.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity." SFAS
No. 150 establishes standards for how companies classify and measure certain
financial instruments with characteristics of both liabilities and equity. It
requires companies to classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances.) SFAS No. 150 is effective
beginning the third quarter of fiscal 2003. The Company believes that the
adoption of this standard will not have a material impact on its financial
position or results of operations.
In November 2002, the Emerging Issues Task Force ("EITF") reached a
consensus on Issue 00-21, "Multiple-Deliverable Revenue Arrangements." EITF
00-21 addresses how to account for arrangements that may involve the delivery or
performance of multiple products, services and/or rights to use assets. The
consensus mandates how to identify whether goods or services or both, which are
to be delivered separately in a bundled sales arrangement, should be accounted
for separately because they are "separate units of accounting." The guidance can
affect the timing of revenue recognition for such arrangements, even though it
does not change rules governing the timing or patterns of revenue recognition of
individual items accounted for separately. The final consensus will be
applicable to agreements entered into in fiscal years beginning after June 15,
2003 with early adoption permitted. Additionally, companies will be permitted to
apply the consensus guidance to all existing arrangements as the cumulative
effect of a change in accounting principle in accordance with APB Opinion No.
20, "Accounting Changes." The Company believes that the adoption of EITF 00-21
will not have a material impact on the Company's financial position or results
of operations.
11
NOTE 10 - COMPREHENSIVE INCOME (LOSS)
The components of comprehensive income, net of taxes, are as follows
(dollars in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------------- --------------------------------
2003 2002 2003 2002
-------------- -------------- -------------- --------------
Net income $ 4,591 $ 6,587 $ 11,536 $ 9,561
Other comprehensive income (loss):
Unrealized gains (losses) on investments 4,749 (11,353) 5,285 (10,534)
Foreign currency translation adjustments 1,393 1,109 1,100 782
-------------- -------------- -------------- --------------
Comprehensive income (loss) $ 10,733 $ (3,657) $ 17,921 $ (191)
============== ============== ============== ==============
NOTE 11 - SEGMENT AND GEOGRAPHIC INFORMATION
Segment income is based on segment revenue less the respective segment's
cost of revenues and selling and marketing expenses. The following segment
reporting information of the Company is provided (dollars in thousands):
NET REVENUES:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------------- ---------------------------------
2003 2002 2003 2002
--------------- --------------- --------------- --------------
Video Technology Division
DVD $ 14,214 $ 11,145 $ 28,143 $ 21,744
Videocassette 1,271 2,439 3,008 3,958
Pay-Per-View 2,699 2,567 5,657 5,715
Consumer Software Division 2,771 1,982 4,480 4,068
Enterprise Software Division 7,102 6,763 14,051 12,991
Music Technology Division 1,085 - 1,847 -
Other 70 44 78 130
--------------- --------------- --------------- --------------
$ 29,212 $ 24,940 $ 57,264 $ 48,606
=============== =============== =============== ==============
SEGMENT INCOME:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------------- -------------------------------
2003 2002 2003 2002
-------------- -------------- -------------- -------------
Video Technology Division $ 15,801 $ 14,223 $ 32,074 $ 27,591
Consumer Software Division 1,625 626 2,216 1,426
Enterprise Software Division 3,470 3,852 7,024 7,102
Music Technology Division 208 - 79 -
Other (144) (231) (266) (406)
-------------- -------------- -------------- -------------
Segment income 20,960 18,470 41,127 35,713
Research and development 4,156 2,832 7,899 5,369
General and administrative 4,648 3,618 8,973 6,666
Amortization of goodwill and other intangibles
from acquisitions 856 689 1,712 1,378
Amortization of deferred stock-based
compensation 752 2,041 1,520 4,124
-------------- -------------- -------------- -------------
$ 10,548 $ 9,290 $ 21,023 18,176
============== ============== ============== =============
12
INFORMATION ON NET REVENUES BY GEOGRAPHIC AREA:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------------- -------------------------------
2003 2002 2003 2002
-------------- -------------- -------------- -------------
United States $ 15,617 $ 12,013 $ 32,453 $ 22,797
International 13,595 12,927 24,811 25,809
-------------- -------------- -------------- -------------
$ 29,212 $ 24,940 $ 57,264 $ 48,606
============== ============== ============== =============
Geographic area information is based upon country of destination for
products shipped and country of contract holder for royalties and license fees.
On June 17, 2003, the Company announced a reorganization into two business
units, effective July 1, 2003: the Entertainment Technologies Group and the
Software Technologies Group. The Entertainment Technologies Group merges the
Video Technology and Music Technology Divisions, along with the SafeDisc(R)
portion of the Consumer Software Division. The Software Technologies Group
absorbs the Enterprise Software Division and the SafeCast(R) business that was
also a part of the Consumer Software Division. The Company has historically
reported segment operating income results for the Video Technology, Consumer
Software, Enterprise Software and Music Technology Divisions. Beginning the
third quarter of 2003, the Company will report operating income results only for
the Entertainment Technologies Group and Software Technologies Group. The
Company will continue to report separate revenue results for various product
lines under the Entertainment Technologies Group (DVD, Videocassettes, PPV,
Music and Games) and the Software Technologies Group (Enterprise Software and
Consumer Software.)
NOTE 12 - CONTINGENCIES
The Company is involved in legal proceedings related to some of its
intellectual property rights.
GLOBETROTTER V. RAINBOW TECHNOLOGIES, ELAN & KEN GREER
In November 1997, Globetrotter filed a patent infringement lawsuit (Case
No. C-98-20419-JF/EAI) in the Federal District Court for the Northern District
of California against Elan Computer Group and its founder, Ken Greer, alleging
infringement of one of its patents and unfair competition and trade practices.
In March 1998, Rainbow Technologies North America, Inc. entered into an
agreement to purchase certain assets of Elan and entered into a litigation
cooperation agreement with Elan regarding the pending Globetrotter litigation.
On or around September 1998, Globetrotter filed a patent infringement suit
against Rainbow Technologies, which was subsequently consolidated with the
action against Elan Computer Group and Ken Greer. Rainbow Technologies and Ken
Greer filed separate counterclaims against Globetrotter and its founder, Matthew
Christiano, alleging antitrust violations, unfair competition, tortious
interference with business relations, and trade libel. Rainbow Technologies and
Ken Greer are seeking compensatory damages, punitive damages, injunctive relief,
and disgorgement of profits. On August 31, 2000, the Company acquired
Globetrotter.
In 1999 and 2001, the Federal District Court granted the partial summary
judgment motions for Rainbow et al that essentially dismissed the patent
infringement case against Rainbow et al.
13
In 2002, the Company filed a series of summary judgment motions to dismiss
some of the counterclaims from Rainbow et al. The Federal District Court granted
all of the Company's motions for summary judgment in full and dismissed all of
the claims against Globetrotter and Matt Christiano.
On December 9, 2002, Ken Greer and Elan filed a notice to appeal the
summary judgment of all their counterclaims by Judge Fogel. In response, on
December 23, 2002, the Company filed a notice to appeal the summary judgment of
all its patent infringement claims against Ken Greer, Elan and Rainbow. On
January 2, 2003, Rainbow filed a notice to appeal the summary judgment of all of
its counterclaims. On March 5, 2003, we entered into a stipulated agreement with
Rainbow to dismiss all cross-appeals between Rainbow and us. On March 31, 2003,
Ken Greer and Elan filed an appeal brief to appeal the summary judgment of its
counterclaims. In the brief, Elan indicated it was abandoning its appeal of the
summary judgment order. This leaves only Ken Greer's appeal and our
cross-appeal. The Company filed an appeal brief on May 12, 2003. Both parties
subsequently filed reply briefs in July 2003. It is believed that an oral
hearing will occur later in 2003.
If an adverse ruling is ultimately reached on the remaining appeals and the
case is returned to a trial court, significant monetary damages may be levied
against the Company, which could have a material adverse effect on the Company's
business, consolidated financial position, results of operations or cash flows.
MACROVISION CORPORATION V. VITEC AUDIO AND VIDEO GMBH
The Company initiated a patent infringement lawsuit in the District Court
of Dusseldorf in March 1999 against ViTec Audio und Video GmbH, a German company
that manufactures what the Company believes to be a video copy protection
circumvention device. ViTec filed a reply brief arguing that its product does
not infringe the Company's patents. The case was heard in the District Court of
Dusseldorf, Germany. The District Court of Dusseldorf ruled adversely against
the Company. The Company appealed the District Court's ruling in July 2000 to
the Court of Appeal in Dusseldorf. A hearing took place in front of the Court of
Appeal in Dusseldorf on August 23, 2001 in which the Court stated that because
the appeal involves complex technical subject matter, the Court would require
technical expert witnesses. The Court selected Professor Dr. Ing. M. Plantholt
as its expert witness. On January 27, 2003, Professor Plantholt submitted his
technical opinion to the Court, and an English translation was made available to
the Company on July 3, 2003. The Company is reviewing the opinion and is
considering its options. A hearing before the Court of Appeal in Dusseldorf is
scheduled for March 4, 2004. In the event of an adverse ruling, the Company may
incur a corresponding decline in demand for its video copy protection
technology, which could harm its business in Germany. In addition, the Company
may be obligated to pay some of ViTec's attorney fees estimated to be US$25,000.
KRYPTON CO., LTD. V. MACROVISION CORPORATION
Krypton Co., Ltd., a Japanese company, filed an invalidation claim against
one of the Company's copy protection patents in Japan. After a hearing in March
1999, the Japanese Patent Office recommended that the Company's patent be
invalidated. On December 27, 1999, the Company appealed this decision to the
Tokyo High Court, and on March 21, 2000, the Tokyo High Court revoked the
Japanese Patent Office's decision. In connection with this ruling, the scope of
the Company's claims under the patent was slightly reduced, but this is not
expected to have a material adverse effect on the value of this patent to the
Company's business. In short, the patent remains valid and part of the Company's
business. On November 22, 2000, Krypton made an appeal in the Tokyo High Court
regarding its earlier decision. On March 3, 2003, the Tokyo High Court rejected
Krypton's arguments and reaffirmed its earlier decision. Krypton may appeal the
decision to the Japanese Supreme Court.
14
Even if an adverse ruling ultimately were reached on this invalidation claim, it
would not have a material adverse effect on the Company's business.
YIELD DYNAMICS, INC. V. MACROVISION CORPORATION AND GLOBETROTTER SOFTWARE, INC.
On October 17, 2002, Yield Dynamics, Inc. filed a federal court action in
the Northern District of California against the Company and Globetrotter
Software, Inc. Yield Dynamics alleges that it created a software interface to
allow its Genesis software product to work with our FLEXLM software and that the
Company distributed this code without Yield Dynamics' permission. Yield Dynamics
has asserted claims of copyright infringement, trade secret misappropriation,
common law unfair competition, and unfair competition under California's
Business and Professions Code. Yield Dynamics seeks an injunction, a
constructive trust on receipts from the licensing or sale of products containing
the interface code, and actual, compensatory and punitive damages. The Company
answered Yield Dynamic's complaint and has asserted a counterclaim for
declaratory relief. The action is currently in the final stages of discovery.
Although the Company does not expect a material adverse result, it is
unable to provide an estimate of the range or amount of potential loss in the
event of an adverse ruling. The Company is contesting the case vigorously.
From time to time the Company has been involved in other disputes and legal
actions arising in the ordinary course of business. In management's opinion,
none of these other disputes and legal actions is expected to have a material
impact on the Company's consolidated financial position, results of operation or
cash flow.
As of June 30, 2003, it was not possible to estimate the liability, if any,
in connection with these matters. Accordingly, no accruals for these
contingencies have been recorded.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING COMMENTARY SHOULD BE READ IN CONJUNCTION WITH THE FINANCIAL
STATEMENTS AND RELATED NOTES CONTAINED IN THE COMPANY'S ANNUAL REPORT ON FORM
10-K FOR THE YEAR ENDED DECEMBER 31, 2002 AS FILED WITH THE SEC. THE DISCUSSION
CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. THESE
STATEMENTS RELATE TO FUTURE EVENTS OR OUR FUTURE FINANCIAL PERFORMANCE. IN SOME
CASES, YOU CAN IDENTIFY THESE FORWARD-LOOKING STATEMENTS BY TERMINOLOGY SUCH AS
"MAY," "WILL," "SHOULD," "EXPECTS," "PLANS," "ANTICIPATES," "BELIEVES,"
"ESTIMATES," "PREDICTS," "POTENTIAL," "INTEND," OR "CONTINUE," AND SIMILAR
EXPRESSIONS. THESE STATEMENTS ARE ONLY PREDICTIONS. OUR ACTUAL RESULTS MAY
DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS
A RESULT OF A VARIETY OF FACTORS, INCLUDING, BUT NOT LIMITED TO, THOSE FACTORS
SET FORTH UNDER THE CAPTION "RISK FACTORS" IN OUR ANNUAL REPORT ON FORM 10-K FOR
THE YEAR ENDED DECEMBER 31, 2002.
OVERVIEW
We were founded in 1983 to develop copy protection and video security
solutions for major motion picture studios and independent video producers. Our
initial products were designed to prevent the unauthorized duplication and
distribution of videocassettes. We have expanded our copy protection
technologies to address the unauthorized copying and distribution of DVDs, CDs,
digital PPV programs and consumer software. We derive royalty-based licensing
revenue from multiple sources, including video content owners, consumer software
publishers, music labels, hardware manufacturers, digital set-top box
manufacturers, digital PPV system operators and commercial
replicators/duplicators. In 2000, we entered the market for Enterprise License
Management ("ELM") solutions for software vendors and software asset management
tools for business through the acquisition of Globetrotter Software, Inc. We
enhanced our presence in the audio copy protection market with our acquisition
of the assets of Midbar Tech (1998) Ltd. in 2002 and the acquisition of patents
and other assets of TTR in June 2003.
The following table provides net revenues information by product line
(dollars in thousands):
THREE MONTHS ENDED
JUNE 30, CHANGE
--------------------------------- ----------------------------
2003 2002 $ %
--------------- -------------- ------------ ------------
Video Technology Division
DVD $ 14,214 $ 11,145 $ 3,069 27.5%
Videocassette 1,271 2,439 (1,168) (47.9)
Pay-Per-View 2,699 2,567 132 5.1
Consumer Software Division 2,771 1,982 789 39.8
Enterprise Software Division 7,102 6,763 339 5.0
Music Technology Division 1,085 - 1,085 N/A
Other 70 44 26 59.1
--------------- -------------- ------------
Total $ 29,212 $ 24,940 $ 4,272 17.1%
=============== ============== ============
SIX MONTHS ENDED
JUNE 30, CHANGE
--------------------------------- ----------------------------
2003 2002 $ %
--------------- -------------- ------------ ------------
Video Technology Division
DVD $ 28,143 $ 21,744 $ 6,399 29.4%
Videocassette 3,008 3,958 (950) (24.0)
Pay-Per-View 5,657 5,715 (58) (1.0)
Consumer Software Division 4,480 4,068 412 10.1
Enterprise Software Division 14,051 12,991 1,060 8.2
Music Technology Division 1,847 - 1,847 N/A
Other 78 130 (52) (40.0)
--------------- -------------- ------------
Total $ 57,264 $ 48,606 $ 8,658 17.8%
=============== ============== ============
16
The following table provides percentage of net revenue information by product
line:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------ -----------------------------
2003 2002 2003 2002
------------- ------------- ------------- ------------
Video Technology Division
DVD 48.7% 44.7% 49.2% 44.7%
Videocassette 4.4 9.8 5.3 8.1
Pay-Per-View 9.2 10.3 9.9 11.8
Consumer Software Division 9.5 7.9 7.8 8.4
Enterprise Software Division 24.3 27.1 24.5 26.7
Music Technology Division 3.7 - 3.2 -
Other 0.2 0.2 0.1 0.3
------------- ------------- ------------- ------------
Total 100.0% 100.0% 100.0% 100.0%
============= ============= ============= ============
On June 17, 2003, we announced our reorganization into two business units,
effective July 1, 2003: the Entertainment Technologies Group and the Software
Technologies Group. The Entertainment Technologies Group merges the Video
Technology and Music Technology Divisions, along with the SafeDisc(R) portion of
the Consumer Software Division. The Software Technologies Group absorbs the
Enterprise Software Division and the SafeCast(R) business that was also a part
of the Consumer Software Division. We have historically reported segment
operating income results for the Video Technology, Consumer Software, Enterprise
Software and Music Technology Divisions. Beginning the third quarter of 2003, we
will report operating income results only for the Entertainment Technologies
Group and Software Technologies Group. We will continue to report separate
revenue results for various product lines under the Entertainment Technologies
Group (DVD, Videocassette, PPV, Music and Games) and the Software Technologies
Group (Enterprise Software and Consumer Software.)
VIDEO TECHNOLOGY DIVISION.
Our customers have included the home video divisions of member companies of
the Motion Picture Association of America ("MPAA"), videocassette duplication
and DVD replication companies and a number of special interest content owners,
such as independent producers of exercise, sports, educational, documentary and
corporate video programs. We typically receive per unit royalties based upon the
number of copy-protected videocassettes or DVDs that are produced by MPAA
studios or other content owners.
DVD COPY PROTECTION. In 1997, we introduced copy protection for DVDs. Our
customers have included member companies of the MPAA and Special Interest rights
owners. Our customers pay per unit royalties for DVD copy protection.
Additionally, we derive license fees from DVD hardware manufacturers. DVD copy
protection revenue represented 48.7% and 44.7% of our net revenues for the three
months ended June 30, 2003 and 2002, respectively, and 49.2% and 44.7% of our
net revenues for the six months ended June 30, 2003 and 2002, respectively. The
increase in DVD copy protection revenue is due to the increase in numbers of
DVDs sold and continued growth in demand for our DVD copy protection solution.
We expect these trends to continue as long as the growth in DVD demand exceeds
future declines in our DVD copy protection average unit royalties and usage
rates.
VIDEOCASSETTE COPY PROTECTION. In 2003, the trend of Hollywood studios
investing proportionally more in copy protecting their DVD titles compared to
VHS releases has continued. Videocassette copy protection revenues represented
4.4% and 9.8% of our net revenues for the three months ended June 30, 2003 and
2002, respectively, and 5.3% and 8.1% of our net revenues for the six months
ended June 30, 2003 and 2002, respectively. We believe videocassette copy
protection revenues will continue to decline
17
as a percentage of our revenues and in absolute terms, as the studios focus more
of their resources on the DVD business line.
We expect that revenues from the MPAA studios will continue to account for
a substantial portion of our net revenues for the foreseeable future. We have
agreements with certain MPAA home video companies for copy protection of a
substantial part of their DVDs and/or videocassettes in the U.S. These
agreements expire at various times ranging from 2003 to 2005. The failure of any
one of these customers to renew its contract or to enter into a new contract
with us on terms that are favorable to us would likely result in a substantial
decline in our net revenues and operating income, and our business would be
harmed.
PPV COPY PROTECTION. In 1993, we introduced digital PPV copy protection to
satellite and cable system operators and to the equipment manufacturers that
supply the satellite and cable industries. We derive a majority of our digital
PPV copy protection revenues from digital set-top box hardware royalties, and
the balance from either up-front license fees or transaction royalties
associated with copy protected PPV programming. Digital PPV revenues were 9.2%
and 10.3% of our net revenues for the three months ended June 30, 2003 and 2002,
respectively, and 9.9% and 11.8% of our net revenues for the six months ended
June 30, 2003 and 2002, respectively. Our agreements with digital PPV system
operators entitle us to transaction-based royalty payments when copy protection
for digital PPV programming is activated. The flatness in our PPV copy
protection revenues is due to the continued weak digital cable and digital
satellite business on a worldwide basis. We believe that revenues from PPV Copy
Protection in total and as a percentage of our total revenues will continue to
vary in the future.
CONSUMER SOFTWARE DIVISION.
We entered into the market for copy protection of consumer software in
1998, when we introduced our CD-ROM consumer software copy protection
technology, called SafeDisc. Customers implementing SafeDisc include major PC
game and educational software publishers. We typically receive unit royalties
based upon the number of copy protected CD-ROMs that are produced by PC game and
educational software publishers. SafeCast is an electronic software distribution
product that facilitates web-based purchases and delivery and product activation
of consumer-oriented software. In recent quarters we have seen increased market
adoption of SafeCast. Consumer Software Division revenues were 9.5% and 7.9% of
our net revenues for the three months ended June 30, 2003 and 2002,
respectively, and 7.8% and 8.4% of our net revenues for the six months ended
June 30, 2003 and 2002. The increase in Consumer Software Division revenue is
from the increased adoption of SafeCast technology by major consumer software
vendors. We believe that revenues from our Consumer Software Division in total
and as a percentage of our total revenues will continue to vary in the future.
ENTERPRISE SOFTWARE DIVISION.
We entered the market for electronic license management of enterprise
software in August 2000. Our Enterprise Software Division generates its revenue
from licensing its software and providing services related to the support and
maintenance of this software. Revenues from Enterprise Software Division were
24.3% and 27.1% of our net revenues for the three months ended June 30, 2003 and
2002, respectively, and 24.5% and 26.7% of our net revenues for the six months
ended June 30, 2003 and 2002, respectively. Despite difficult economic
conditions for enterprise software companies, our revenues, in absolute terms,
for the three and six months ended June 30, 2003 have increased compared to the
same periods in the prior year. We believe that revenues from our Enterprise
Software Division in total and as a percentage of our total revenues will
continue to vary in the future.
18
MUSIC TECHNOLOGY DIVISION.
In November 2002, we acquired the assets and operations of Midbar Tech
(1998) Ltd., a leading supplier of copy protection solutions for the music
industry, for approximately $17.8 million in cash and related acquisition costs.
In addition, we have agreed to additional contingent consideration up to $8.0
million based on a percentage of net revenues of the Music Technology Division
through December 31, 2004. The transaction has been accounted for as the
purchase of a business. In connection with the purchase in November, we recorded
goodwill of $6.9 million and identifiable intangibles of $4.9 million. In the
first half of 2003, we also recorded additional goodwill of approximately
$480,000 which represents contingent consideration payments we are required to
make to Midbar Tech (1998) Ltd. shareholders based on a percentage of the net
revenues of our Music Technology Division, as noted above. In June 2003, we
acquired the patents and other assets of TTR for $5.1 million in cash and the
surrender of 1,880,937 shares of TTR common stock that we originally purchased
in January 2000. We recorded a realized gain of $395,000 for the excess of the
market value of such TTR stock on the closing date of the acquisition over the
adjusted cost basis of such stock. Our copy protection products in this area are
used by customers for copy protection, authentication, and rights management for
music CDs. Music Technology Division's revenues were 3.7% and 3.2% of our net
revenues for the three and six months ended June 30, 2003, respectively. We had
no revenues from our Music Technology Division during the periods ended June 30,
2002. We expect revenues from our Music Technology Division to vary in the
future.
SEASONALITY OF BUSINESS.
We have experienced significant seasonality in our business, and our
consolidated financial condition and results of operations are likely to be
affected by seasonality in the future. We have typically experienced our highest
revenues in the fourth quarter of each calendar year followed by lower revenues
and operating income in the first quarter, and at times in subsequent quarters.
We believe that this trend has been principally due to the tendency of certain
of our customers to release new video, audio, and consumer software titles
during the year-end holiday shopping season, while our operating expenses are
incurred more evenly throughout the year. In addition, revenues tend to be lower
in the summer months, particularly in Europe.
COSTS AND EXPENSES.
Our cost of revenues consists primarily of service fees paid to licensed
duplicators and replicators that produce videocassettes, DVDs and CD-ROMs for
content owners and costs of equipment used to apply our technology. Also
included in cost of revenues are software product support costs, direct labor
and benefit costs of employees time spent on billable consulting or training,
patent defense costs, amortization of licensed technologies, amortization of
certain intangibles from acquisitions and patent amortization. Our research and
development expenses are comprised primarily of employee compensation and
benefits, consulting and recruiting fees, tooling and supplies and an allocation
of facilities costs. Our selling and marketing expenses are comprised primarily
of employee compensation and benefits, consulting and recruiting fees, travel,
advertising and an allocation of facilities costs. Our general and
administrative expenses are comprised primarily of employee compensation and
benefits, consulting and recruiting fees, travel, professional fees and an
allocation of facilities costs.
19
CRITICAL ACCOUNTING POLICIES
The 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 U.S.
The preparation of these financial statements requires management 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, bad debts, investments, intangible assets and
income taxes. Our estimates are based on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances.
Actual results may differ from these estimates.
We have identified the accounting policies below as critical to our
business operations and the understanding of our results of operations.
REVENUE RECOGNITION
Our revenue primarily consists of royalty fees on copy-protected products
on a per unit basis, licenses for our copy protection technologies, licenses for
our software products, and related maintenance and services revenues.
ROYALTY REVENUES
Royalty revenue from the replication of videocassettes, DVDs, and CDs is
recognized when realized or realizable and earned. We rely on royalty reports
from our customers and third parties as our basis for revenue recognition. In
our DVD, videocassette, and consumer software businesses, we have established
significant experience with certain customers to reasonably estimate current
period volume for purposes of making an accurate revenue accrual. Accordingly,
royalty revenue from these customers is recognized as earned. Revenue from
customers in our PPV and Music Technology Division is recognized only as
reported, due to the timing of receipt of reports in PPV, and the embryonic
stage and volume volatility of the audio market. Advanced royalty fees
attributable to minimum copy quantities or shared revenues are deferred until
earned. In the case of agreements with minimum guaranteed royalty payments with
no specified volume, revenue is recognized on a straight-line basis over the
life of the agreement.
TECHNOLOGY LICENSING REVENUES
Technology licensing revenue, which applies principally to DVD and PC
sub-assembly manufacturers, digital PPV, cable and satellite system operators,
and digital set-top decoder manufacturers, is recognized upon establishment of
persuasive evidence of an arrangement, performance of all significant
obligations and determination that collection of a fixed and determinable
license fee is considered probable.
SOFTWARE LICENSING REVENUES
We recognize revenue on our software products in accordance with SOP 97-2,
"Software Revenue Recognition," as amended by SOP 98-9 "Modification of SOP
97-2." We recognize revenue when all of the following criteria are met:
persuasive evidence of an arrangement exists; delivery of the product has
occurred; no significant obligations by us remain; the fee is fixed and
determinable; and collectibility is probable. We consider all arrangements with
payment terms extending beyond six months not to be fixed or determinable and,
accordingly, revenue is recognized as payments become due from the customer
under such arrangements. We assess collectibility based on a number of factors,
20
including the customer's past payment history and current creditworthiness. If
collectibility is not considered probable, revenue is recognized when the fee is
collected from the customer.
For license agreements in which non-standard customer acceptance clauses
are a condition to earning the license fees, revenue is not recognized until
acceptance occurs. For arrangements containing multiple elements, such as
software license fees, consulting services and maintenance, or multiple products
and where vendor-specific objective evidence of fair value ("VSOE") exists for
all undelivered elements, we account for the delivered elements in accordance
with the "residual method." Under the residual method, the fair value of the
undelivered elements is deferred and the remaining portion of the arrangement
fee is recognized as revenue. For arrangements containing multiple elements
where VSOE does not exist, all revenue is deferred until such time that VSOE is
evidenced or all elements of the arrangement have been delivered, or if the only
undelivered element is maintenance, revenue is recognized pro rata over the
maintenance contract period. We also enter into term license agreements in which
the license fee is recognized ratably over the term of the license period
(generally one year).
When licenses are sold together with consulting and implementation
services, license fees are recognized upon delivery provided that (1) the above
criteria have been met, (2) payment of the license fees is not dependent upon
performance of the consulting and implementation services, and (3) the services
are not essential to the functionality of the software. For arrangements where
services are essential to the functionality of the software, both the license
and services revenue are recognized in accordance with the provisions of SOP
81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts." Arrangements that allow the Company to make
reasonably dependable estimates relative to contract costs and the extent of
progress toward completion are accounted for using the percentage-of-completion
method. Arrangements that do not allow the Company to make reasonably dependable
estimates are accounted for using the completed-contracts-method. Because the
completed-contracts method precludes recognition of performance under the
contract as the work progresses, it does not reflect current financial
performance when the contract extends beyond one accounting period, and it
therefore may result in uneven recognition of revenue and gross margin.
PROFESSIONAL SERVICES REVENUES
We provide consulting and training services to our customers. Revenue from
such services is generally recognized as the services are performed, except in
instances where services are included in an arrangement accounted for under SOP
81-1. Professional services revenues are included in services revenue in the
accompanying condensed consolidated financial statements.
MAINTENANCE REVENUES
Maintenance agreements generally call for us to provide technical support
and software updates to customers. Maintenance revenue is deferred and
recognized ratably over the maintenance contract period (which is generally one
year) and included in services revenue in the accompanying condensed
consolidated financial statements.
VALUATION OF STRATEGIC INVESTMENTS
As of June 30, 2003, the adjusted cost of our strategic investments totaled
$32.3 million. This included our investments in public and non-public companies.
We review our investments in non-public companies and estimate the amount
of any impairment incurred during the current period based on specific analysis
of each investment, considering the activities
21
of and events occurring at each of the underlying portfolio companies during the
period. For investments in public companies, we compare our basis in the
investment to the average daily trading prices of the security over the prior
six months to determine if an other-than-temporary impairment has occurred. If
the six-month average is less than the current cost basis, we record a charge to
the statement of income for the difference between the market price at period
end and the current cost basis.
For equity investments in non-public companies for which there is no market
where their value is readily determinable, we review each investment for
indicators of impairment on a regular basis based primarily on achievement of
business plan objectives and current market conditions, among other factors. The
primary business plan objectives we consider include, among others, those
related to financial performance such as liquidity, achievement of planned
financial results or completion of capital raising activities, and those that
are not primarily financial in nature such as the launching of technology or the
hiring of key employees. If it is determined that an other-than-temporary
impairment has occurred with respect to an investment in a portfolio company, in
the absence of quantitative valuation metrics, such as a recent financing round,
management estimates the impairment and/or the net realizable value of the
portfolio investment based on a hypothetical liquidation at book value approach
as of the reporting date. Future adverse changes in market conditions or poor
operating results of underlying investments could result in losses or an
inability to recover the current carrying value of the investments thereby
requiring further impairment charges in the future. Based on these measurements,
$4.3 million of other-than-temporary impairment losses from an investment in a
non-public company were recorded during the three and six months ended June 30,
2003. This was partially offset by $395,000 of realized gains from the surrender
of our stock in TTR (see Note 3 of Notes to Condensed Consolidated Financial
Statements.) $5.5 million of other-than-temporary impairment losses were
recorded during the six months ended June 30, 2002. This included a $2.5 million
charge for an investment in a public company and a $3.0 million charge for an
investment in a non-public company.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill represents the excess of costs over fair value of assets of
businesses acquired. We adopted the provisions of SFAS No. 142, "Goodwill and
Other Intangible Assets," as of January 1, 2002. Goodwill and intangible assets
acquired in a purchase business combination and determined to have an indefinite
useful life are not amortized, but instead are tested for impairment at least
annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also
requires that intangible assets with estimable useful lives be amortized over
their respective estimated useful lives to their estimated residual values, and
reviewed for impairment in accordance with SFAS No. 144, "Accounting for
Impairment or Disposal of Long-Lived Assets."
Goodwill and intangible assets not subject to amortization are tested
annually for impairment, and are tested for impairment more frequently if events
and circumstances indicate that the assets might be impaired. During the six
months ended June 30, 2003, there were no triggering events which required us to
test for impairment prior to our annual impairment analysis.
In connection with our impairment analysis to be performed annually in our
fourth quarter, we are required to perform an assessment of whether there is an
indication that goodwill is impaired. To accomplish this, we are required to
determine the carrying value of each reporting unit by assigning the assets and
liabilities, including the existing goodwill and intangible assets, to those
reporting units. To the extent the carrying amount of a reporting unit exceeds
its fair value, we would be required to perform the second step of the
impairment analysis, as this is an indication that the reporting unit goodwill
may be impaired. In this step, we compare the implied fair value of the
reporting unit goodwill with the carrying amount of the reporting unit goodwill.
The implied fair value of goodwill is determined by allocating the fair value of
the reporting unit to all of the assets (recognized and unrecognized) and
liabilities of the
22
reporting unit in a manner similar to a purchase price allocation, in accordance
with SFAS No. 141, "Business Combinations." The residual fair value after this
allocation is the implied fair value of the reporting unit goodwill. To the
extent the implied fair value of goodwill of each reporting is less than its
carrying amount we would be required to recognize an impairment loss.
IMPAIRMENT OF LONG-LIVED ASSETS
In accordance with SFAS No. 144, long-lived assets, such as property and
equipment, and purchased intangibles subject to amortization, are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset group may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset group to estimated undiscounted future cash flows expected to be
generated by the asset group. If the carrying amount of an asset group exceeds
its estimated future cash flows, an impairment charge is recognized by the
amount by which the carrying amount of the asset group exceeds the fair value of
the asset group. Assets to be disposed of would be separately presented in the
balance sheet and reported at the lower of the carrying amount or fair value
less costs to sell, and would no longer be depreciated. The assets and
liabilities of a disposal group classified as held for sale would be presented
separately in the appropriate asset and liability sections of the balance sheet.
For the six months ended June 30, 2003, no impairment charges were recorded for
long-lived assets.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
Management estimates the collectibility of our accounts receivable on an
account-by-account basis. We record an increase in the allowance for doubtful
accounts when the prospect of collecting a specific account receivable becomes
doubtful. In addition, we establish a non-specific reserve, using a specified
percentage of the outstanding balance of all such accounts based on historical
bad debt loss experience. Management specifically analyzes accounts receivable
and historical bad debts experience, customer creditworthiness, current economic
trends, international situations (such as currency devaluation), and changes in
our customer payment history when evaluating the adequacy of the allowance for
doubtful accounts. If the financial condition of our customers were to
deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required.
INCOME TAXES
We account for income taxes using the asset and liability method. As of
June 30, 2003 deferred tax assets net of valuation allowances, totaled $15.1
million. Deferred tax assets, related valuation allowances and deferred tax
liabilities are determined separately by tax jurisdiction. We believe sufficient
uncertainty exists regarding our ability to realize our deferred tax assets in
certain foreign jurisdictions and, accordingly, a valuation allowance has been
established against the deferred tax assets in those jurisdictions. We believe
that it is more likely than not that the results of future operations will
generate sufficient taxable income to utilize these deferred tax assets, net of
valuation allowance. While we have considered future taxable income and ongoing
prudent and feasible tax planning strategies in assessing the need for any
valuation allowance, in the event we were to determine that we will be able to
realize our deferred tax assets in the future in excess of the net recorded
amount, an adjustment to the deferred tax asset would increase income in the
period such determination was made. Likewise, should we determine that we would
not be able to realize all or part of our net deferred tax asset in the future,
an adjustment to the deferred tax asset would be charged to income in the period
such determination was made. Our effective tax rate is directly affected by the
relative proportions of domestic and international revenue and income before
taxes, as well as the estimated level of annual pre-tax income. We are also
subject to changing tax laws in the multiple jurisdictions in which we operate.
23
RESULTS OF OPERATIONS
NET REVENUES. Total net revenues for the three and six month periods ended
June 30, 2003 increased 17.1% and 17.8%, respectively, from the corresponding
prior year periods. DVD copy protection revenues for the three and six month
periods ended June 30, 2003 increased 27.5% and 29.4%, respectively, from the
corresponding prior year periods due to the continued growth in demand of the
DVD format and a strong hit title release schedule that more than offset modest
declines in our average unit royalties. Our DVD copy protection revenues in 2002
were reduced by a $2.3 million refund resulting from a customer's self-reporting
error detected in 2002. During the three and six months ended June 30, 2003, the
increase in DVD copy protection revenues included approximately $917,000 in
revenue in a partial resolution of this customer overreporting claim. Revenues
from videocassette copy protection for the three and six month periods ended
June 30, 2003 decreased 47.9% and 24.0%, respectively, from the corresponding
prior year periods reflecting the continuing trend for Hollywood studios to
invest more proportionally in copy protecting their DVD titles compared to VHS
releases. Digital PPV copy protection revenues for the three months ended June
30, 2003 increased 5.1% from the corresponding prior year period due to modest
growth despite the continued weak digital cable and digital satellite business
on a worldwide basis. Digital PPV copy protection revenues for the six months
ended June 30, 2003 decreased 1.0% from the corresponding prior year period.
Consumer Software Division revenues for the three and six month periods ended
June 30, 2003 increased 39.8% and 10.1%, respectively, from the corresponding
prior year periods, resulting from the increased adoption of our SafeCast
technology by major consumer software vendors. Enterprise Software Division
revenues for the three and six month periods ended June 30, 2003 increased 5.0 %
and 8.2%, respectively, from the corresponding prior year periods, primarily due
to an increase in annual licensing and maintenance revenues.
LICENSE REVENUES. Our license revenues for the three and six months ended
June 30, 2003 increased 17.2% and 18.1%, respectively, from the corresponding
prior year periods primarily due to increases in our revenues derived by our
Video Technology Division in the DVD copy protection area, revenues from our
Music Technology Division formed in November 2002 and increases in revenues in
our Enterprise Software Division.
SERVICE REVENUES. Our service revenues for the three and six months ended
June 30, 2003 increased 16.9% and 15.7%, respectively, from the corresponding
prior year periods primarily due to an increase in maintenance revenues in our
Enterprise Software Division, as well as an increase in consulting revenue.
COST OF REVENUES - LICENSE FEES. Cost of revenues from license fees for the
three and six months ended June 30, 2003 decreased $340,000 and $566,000,
respectively, from the corresponding prior year periods. As a percentage of
license revenues, cost of revenues from license fees decreased from 6.8% in the
second quarter of 2002 to 4.5% in the second quarter of 2003. As a percentage of
license revenues, cost of revenues from license fees decreased from 6.2% for the
six months ended June 30, 2002 to 4.1% for the six months ended June 30, 2003.
The decreases are primarily due to lower patent defense costs relating to the
Rainbow litigation in 2003 compared to corresponding prior year periods in 2002
(see Note 12 of Notes to Condensed Consolidated Financial Statements).
COST OF REVENUES - SERVICE FEES. Cost of revenues from service fees for the
three and six months ended June 30, 2003 increased $232,000 and $277,000,
respectively, from the corresponding prior year periods. As a percentage of
service revenues, cost of revenues from service fees increased from 14.3% in the
second quarter of 2002 to 20.0% in the second quarter of 2003. As a percentage
of service revenues, cost of revenues from service fees increased from 17.2% for
the six months ended June 30, 2002 to 19.7% for the six months ended June 30,
2003. The increases are primarily due to the increase in the size of our
24
consulting practice which required increased hiring of technical consultants and
resulted in higher employee related expenses. Additionally, this increase was
partially offset by the deferral of certain costs totaling $410,000 directly
associated with a customer contract currently being accounted for under the
completed contract provisions of SOP 81-1. We anticipate our cost of revenues
from service fees will increase in the future.
COST OF REVENUES - AMORTIZATION OF INTANGIBLES FROM ACQUISITIONS. Cost of
revenues from amortization of intangibles from acquisitions for the three and
six months ended June 30, 2003 increased $316,000 and $632,000, respectively,
from the corresponding prior year periods. This increase was primarily due to
the acquisition of Midbar Tech (1998) Ltd., which increased our intangible
assets subject to amortization.
RESEARCH AND DEVELOPMENT. Research and development expenses increased by
$1.3 million or 46.8% from $2.8 million in the second quarter of 2002 to $4.2
million in the second quarter of 2003. Research and development expenses
increased by $2.5 million for the six months ended June 30, 2003 or 47.1% from
$5.4 million for the six months ended June 30, 2002 to $7.9 million for the six
months ended June 30, 2003. The increase is primarily due to increased headcount
and increased costs for contractors and consultants as we increase our research
and development efforts. These increases were primarily in our Music Technology
Division, which includes headcount related to our November 2002 acquisition of
Midbar Tech (1998) Ltd. Research and development expenses increased as a
percentage of net revenues from 11.4% in the second quarter of 2002 to 14.2% in
the second quarter of 2003 and from 11.0% for the six months ended June 30, 2002
to 13.8% for the six months ended June 30, 2003. We expect research and
development expenses to continue to increase in absolute terms and as a
percentage of net revenues over the prior year periods as a result of expected
increases in research and development activity as we invest in the development
of new technologies across all our business areas.
SELLING AND MARKETING. Selling and marketing expenses increased by $1.9
million or 41.2% from $4.6 million in the second quarter of 2002 to $6.5 million
in the second quarter of 2003. Selling and marketing expenses increased by $3.5
million or 37.8% from $9.3 million for the six months ended June 30, 2002 to
$12.9 million for the six months ended June 30, 2003. This increase was
primarily due to higher compensation expenses and increased headcount. Selling
and marketing expenses increased as a percentage of net revenues from 18.4% in
the second quarter of 2002 to 22.2% in the second quarter of 2003 and from 19.2%
for the six months ended June 30, 2002 to 22.5% for the six months ended June
30, 2003. We expect selling and marketing expenses to continue to increase in
absolute terms in the future.
GENERAL AND ADMINISTRATIVE. General and administrative expenses increased
by $1.0 million or 28.5% from $3.6 million in the second quarter of 2002 to $4.6
million in the second quarter of 2003. General and administrative expenses
increased by $2.3 million or 34.6% from $6.7 million for the six months ended
June 30, 2002 to $9.0 million for the six months ended June 30, 2003. The
increase is due primarily to higher compensation expense and increased
headcount, increased Directors' and Officers' insurance expense, as well as
increased legal fees (excluding legal fees for patent defense which are included
in cost of sales for license fees). General and administrative expenses
increased as a percentage of net revenues from 14.5% in the second quarter of
2002 to 15.9% in the second quarter of 2003 and from 13.7% for the six months
ended June 30, 2002 to 15.7% for the six months ended June 30, 2003. We expect
our general and administrative expenses to increase moderately in absolute terms
in the future as we continue to support the expansion of our business and comply
with the requirements of the Sarbanes-Oxley Act of 2002.
AMORTIZATION OF INTANGIBLES FROM ACQUISITIONS. We amortize intangibles
relating to the acquisition of C-Dilla in June 1999 on a straight-line basis
over three to seven years based on expected useful lives of existing products
and technologies, included in cost of revenues, and non-compete
25
agreements, included in operating expenses. We amortized $149,000 and $298,000
for the three and six months ended June 30, 2002, respectively, related to
non-compete agreements. There was no comparable amortization in the second
quarter of 2003. We also amortized $417,000 in each of the second quarters of
2003 and 2002, and $833,000 for each of the six month periods ended June 30,
2003 and 2002, related to intangibles for existing products and technologies.
These amounts are included in our cost of revenues.
We also amortize intangibles relating to the acquisition of net assets of
Productivity through Software plc ("PtS"), the European distributor for the
Enterprise Software Division, on a straight-line basis over three years based on
the expected useful lives of the existing customer base. We amortized $136,000
and $123,000 in the second quarter of 2003 and 2002, respectively, and $269,000
and $247,000 for the six months ended June 30, 2003 and 2002, respectively.
These amounts are included in our cost of sales.
We amortize intangibles relating to the acquisition of Midbar Tech (1998)
Ltd. in November 2002 on a straight-line basis over three to five years based on
expected useful lives of existing technology, existing contracts, patents and
trademarks. We amortized $303,000 and $610,000 in the three and six months
periods ended June 30, 2003, respectively. These amounts are included in our
cost of sales.
AMORTIZATION OF DEFERRED STOCK-BASED COMPENSATION. In connection with the
acquisition of Globetrotter, approximately 783,742 Globetrotter employee stock
options were exchanged for Macrovision stock options, resulting in a deferred
stock-based compensation charge of approximately $37.9 million. The amortization
of the deferred stock-based compensation for the second quarters of 2003 and
2002 were $752,000 and $2.0 million, respectively. The amortization of the
deferred stock-based compensation for the six month periods ended June 30, 2003
and 2002 were $1.5 million and $4.1 million, respectively. The decrease in
amortization from the corresponding prior year periods to 2003 was due to stock
option terminations as certain former Globetrotter employees left the Company.
The expense associated with this stock-based compensation will continue to
result in substantial non-cash compensation charges to future earnings through
2004.
IMPAIRMENT LOSSES ON INVESTMENTS, NET. During the six months ended June 30,
2003 and 2002, we recorded charges totaling $3.9 million and $5.5 million,
respectively, relating to other than temporary impairments in our public and
non-public company investments.
INTEREST AND OTHER INCOME, NET. Interest and other income decreased $1.1
million or 53.9% from $2.1 million in the second quarter of 2002 to $1.0 million
in the second quarter of 2003. Interest and other income decreased $2.1 million
or 50.7% from $4.2 million for the six months ended June 30, 2002 to $2.1
million for the six months ended June 30, 2003. The decrease is due primarily to
lower interest rates.
INCOME TAXES. For the second quarter of 2003, we recorded income taxes of
$3.1 million, compared to income taxes for the second quarter of 2002 of $4.8
million. The effective tax rate of 40.0% reflects our current estimate of
domestic and international revenue and income before taxes, as well as the
estimated level of pre-tax income for fiscal 2003. The decrease in the effective
tax rate from 2002 was due to changes in our international operations resulting
in a shift of our taxable income to more favorable tax jurisdictions, and also a
reduction in the amortization of deferred stock-based compensation, which is not
tax deductible.
26
LIQUIDITY AND CAPITAL RESOURCES
We have financed our operations primarily from cash generated by
operations, principally our copy protection businesses and our electronic
license management business. Our operating activities provided net cash of $31.6
million and $34.2 million in the six months ended June 30, 2003 and 2002,
respectively. Cash provided by operating activities decreased primarily due to a
reduction in net income after excluding non-cash charges. The availability of
cash generated by our operations could be affected by, but not limited to, those
factors set forth under the caption "Risk Factors" in our Annual Report on Form
10-K for the year ended December 31, 2002.
Investing activities used net cash of $96.5 million in the six months ended
June 30, 2003 and provided net cash of $28.8 million in the six months ended
June 30, 2002. Cash from investing activities decreased from the prior year
period mainly from the maturity of short-term marketable investments and
investments in money market funds that were reinvested in longer term
investments for more favorable interest rates. The decrease in capital
expenditures of $2.1 million is primarily due to leasehold improvements and
furniture and fixtures for our new office space, which occurred in the first
quarter of 2002 resulting in a larger amount of capital expenditures in the six
months ended June 30, 2002 when compared to the six months ended June 30, 2003.
Net cash provided by financing activities (primarily proceeds from stock
option exercises and employee stock program purchases) was $2.5 million for the
six months ended June 30, 2003. Net cash used in financing activities was
$842,000 for the six months ended June 30, 2002. The increase in cash provided
by financing activities is due to $3.4 million used to repurchase 3.0 million
shares of treasury stock during the six months ended June 30, 2002.
At June 30, 2003, we had $36.5 million in cash and cash equivalents, $110.7
million in short-term investments and $99.3 million in long-term marketable
investment securities, which included the fair market value of our strategic
investment in Digimarc, a public company. At December 31, 2002, we had $98.7
million in cash and cash equivalents, $73.0 million in short-term investments
and $38.7 million in long-term marketable investment securities, which included
the fair market value of our strategic investments in two public companies:
Digimarc and TTR. The decrease in cash and cash equivalents is mainly due to the
re-investment of money market funds in longer term investments for more
favorable interest rates, offset by favorable cash flow provided by operations.
The increase in long-term marketable investment securities is due to the
reinvestment of money market funds into longer term investments mentioned above,
and also the increase in market value of Digimarc, offset by the disposition of
TTR Technologies in the second quarter of 2003 (See Note 3 of Notes to Condensed
Consolidated Financial Statements.) We have no material commitments for capital
expenditures and anticipate that capital expenditures for the remainder of the
year will not exceed $3.0 million. We also have future minimum lease payments of
approximately $32.2 million under operating leases. We believe that the current
available funds and cash flows generated from operations will be sufficient to
meet our working capital and capital expenditure requirements for the
foreseeable future. We may also use cash to acquire or invest in businesses or
to obtain the rights to use certain technologies.
In November 2002, we acquired the assets and operations of Midbar Tech
(1998) Ltd., a leading supplier of copy protection solutions for the music
industry, for approximately $17.8 million in cash and related acquisition costs.
In addition, we are subject to additional contingent consideration up to $8.0
million based on a percentage of net revenues of the Music Technology Division
until December 31, 2004.
27
In May 2003, we acquired patents and other assets of TTR Technologies, Inc.
("TTR") for $5.1 million in cash and the surrender of 1,880,937 shares of TTR
common stock that we purchased in January 2000. We recorded a realized gain of
$395,000 for the excess of the market value of such TTR stock on the asset
acquisition date over the adjusted cost basis of such stock. This gain has been
included in "Impairment losses on investments, net" in the accompanying
condensed consolidated financial statements.
Because a significant portion of our cash inflows were generated by
operations, our ability to generate positive cash flow from operations may be
jeopardized by fluctuations in our operating results. Such fluctuations can
occur as a result of decreases in demand for our copy protection products, our
electronic license management products, or due to other business risks
including, but not limited to, those factors set forth under the caption "Risk
Factors" in our Annual Report on Form 10-K for the year ended December 31, 2002.
In May 2002, the Board of Directors authorized a 5.0 million share
repurchase program which allowed us to purchase shares in the open market from
time-to-time at prevailing market prices, through block trades or otherwise, or
in negotiated transactions off the market, at the discretion of our management.
Our repurchases of shares of common stock have been recorded as treasury stock
and resulted in a reduction of stockholders' equity. Through June 30, 2003, we
had repurchased 3.0 million shares at a total cost of $38.5 million. As of June
30, 2003, 2.0 million shares remained authorized for repurchase.
CONTRACTUAL OBLIGATIONS.
The Company leases its facilities and certain equipment pursuant to
non-cancelable operating lease agreements. Future minimum lease payments
pursuant to these leases as of June 30, 2003 were as follows (in thousands):
Operating
Leases
------------
2003 $ 1,633
2004 3,365
2005 3,340
2006 3,354
2007 3,460
2008 and thereafter 17,074
------------
Total $ 32,226
============
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 9 of Notes to Condensed Consolidated Financial Statements.
28
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to financial market risks, including changes in interest
rates, foreign exchange rates and security investments. Changes in these factors
may cause fluctuations in our earnings and cash flows. We evaluate and manage
the exposure to these market risks as follows:
FIXED INCOME INVESTMENTS. We have an investment portfolio of fixed income
securities, including those classified as cash equivalents, short-term
investments and long-term marketable investments securities of $246.5 million as
of June 30, 2003. These securities are subject to interest rate fluctuations. An
increase in interest rates could adversely affect the market value of our fixed
income securities.
We do not use derivative financial instruments in our investment portfolio
to manage interest rate risk. We limit our exposure to interest rate and credit
risk, however, by establishing and strictly monitoring clear policies and
guidelines for our fixed income portfolios. The primary objective of these
policies is to preserve principal while at the same time maximizing yields,
without significantly increasing risk. A hypothetical 50 basis point increase in
interest rates would result in an approximate $639,000 decrease (approximately
0.3%) in the fair value of our available-for-sale securities as of June 30,
2003.
FOREIGN EXCHANGE RATES. Due to our reliance on international and export
sales, we are subject to the risks of fluctuations in currency exchange rates.
Because a substantial majority of our international and export revenues are
typically denominated in U.S. dollars, fluctuations in currency exchange rates
could cause our products to become relatively more expensive to customers in a
particular country, leading to a reduction in sales or profitability in that
country. Our subsidiaries in the U.K. and Japan operate in their local currency,
which mitigates a portion of the exposure related to the portion of our revenues
that are denominated in such currencies.
STRATEGIC INVESTMENTS. We currently hold minority equity interests in
Command Audio, Digimarc, Digital Fountain, InterActual, iVAST, NTRU
Cryptosystems, RioPort, Inc., SecureMedia and Widevine Technologies. These
investments, with a carrying value totaling $32.3 million (which included $31.6
million for our investment in Digimarc and $714,000 for investments in
non-public companies), represented 9.2% of our total assets as of June 30, 2003.
Digimarc, a publicly traded company, is subject to price fluctuations based on
the public market. Command Audio, Digital Fountain, InterActual, iVAST, NTRU
Cryptosystems, RioPort, Inc. and Widevine Technologies are non-public companies.
There is no active trading market for their securities and our investments in
them are illiquid. As of June 30, 2003, the carrying value of these non-public
companies is $714,000, which consists of the carrying value of iVast. All other
non-public companies listed have a carrying value of $0 as of June 30, 2003. We
may never have an opportunity to realize a return on our investment in these
non-public companies, and we may in the future be required to write off all or
part of the remaining carrying value of these investments. During the six months
ended June 30, 2003, the Company recorded total net charges of $3.9 million
relating to impairment losses considered to be other than temporary declines in
the value of certain strategic long term investments in non-public companies of
$4.3 million and realized gains from the surrender of TTR stock of $395,000.
During the six months ended June 30, 2002, we recorded charges of $5.5 million
relating to other than temporary impairments in our public and non-public
company investments.
29
ITEM 4. CONTROLS AND PROCEDURES
(a) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. The Company maintains
disclosure controls and procedures that are designed to ensure that
information required to be disclosed in the Company's Exchange Act reports
is recorded, processed, summarized and reported within the time periods
specified in the SEC's rules and forms, and that such information is
accumulated and communicated to the Company's management, including its
Chief Executive Officer and Chief Financial Officer, as appropriate, to
allow timely decisions regarding required disclosure based closely on the
definition of "disclosure controls and procedures" in Rule 13a-15(e). In
designing and evaluating the disclosure controls and procedures, management
recognized that any controls and procedures, no matter how well designed
and operated, can provide only reasonable assurance of achieving the
desired control objectives, and management necessarily was required to
apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures.
Within 90 days prior to the filing of this report, the Company carried out
an evaluation, under the supervision and with participation of the
Company's management, including the Company's Chief Executive Officer and
the Company's Chief Financial Officer, of the effectiveness of the design
and operation of the Company's disclosure controls and procedures. Based on
the foregoing, the Company's Chief Executive Officer and Chief Financial
Officer concluded that the Company's disclosure controls and procedures
were effective.
(b) CHANGES IN INTERNAL CONTROLS. There have been no significant changes in the
Company's internal controls or in other factors that could significantly
affect the internal controls subsequent to the date the Company completed
its evaluation.
30
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is involved in legal proceedings related to some of its
intellectual property rights.
GLOBETROTTER V. RAINBOW TECHNOLOGIES, ELAN & KEN GREER
In November 1997, Globetrotter filed a patent infringement lawsuit (Case
No. C-98-20419-JF/EAI) in the Federal District Court for the Northern District
of California against Elan Computer Group and its founder, Ken Greer, alleging
infringement of one of its patents and unfair competition and trade practices.
In March 1998, Rainbow Technologies North America, Inc. entered into an
agreement to purchase certain assets of Elan and entered into a litigation
cooperation agreement with Elan regarding the pending Globetrotter litigation.
On or around September 1998, Globetrotter filed a patent infringement suit
against Rainbow Technologies, which was subsequently consolidated with the
action against Elan Computer Group and Ken Greer. Rainbow Technologies and Ken
Greer filed separate counterclaims against Globetrotter and its founder, Matthew
Christiano, alleging antitrust violations, unfair competition, tortious
interference with business relations, and trade libel. Rainbow Technologies and
Ken Greer are seeking compensatory damages, punitive damages, injunctive relief,
and disgorgement of profits. On August 31, 2000, the Company acquired
Globetrotter.
In 1999 and 2001, the Federal District Court granted the partial summary
judgment motions for Rainbow et al that essentially dismissed the patent
infringement case against Rainbow et al.
In 2002, the Company filed a series of summary judgment motions to dismiss
some of the counterclaims from Rainbow et al. The Federal District Court granted
all of the Company's motions for summary judgment in full and dismissed all of
the claims against Globetrotter and Matt Christiano.
On December 9, 2002, Ken Greer and Elan filed a notice to appeal the
summary judgment of all their counterclaims by Judge Fogel. In response, on
December 23, 2002, the Company filed a notice to appeal the summary judgment of
all its patent infringement claims against Ken Greer, Elan and Rainbow. On
January 2, 2003, Rainbow filed a notice to appeal the summary judgment of all of
its counterclaims. On March 5, 2003, we entered into a stipulated agreement with
Rainbow to dismiss all cross-appeals between Rainbow and us. On March 31, 2003,
Ken Greer and Elan filed an appeal brief to appeal the summary judgment of its
counterclaims. In the brief, Elan indicated it was abandoning its appeal of the
summary judgment order. This leaves only Ken Greer's appeal and our
cross-appeal. We filed our appeal brief on May 12, 2003. Both parties
subsequently filed reply briefs in July 2003. It is believed that an oral
hearing will occur later in 2003.
If an adverse ruling is ultimately reached on the remaining appeals and the
case is returned to a trial court, significant monetary damages may be levied
against the Company, which could have a material adverse effect on the Company's
business, consolidated financial position, results of operations or cash flows.
MACROVISION CORPORATION V. VITEC AUDIO AND VIDEO GMBH
The Company initiated a patent infringement lawsuit in the District Court
of Dusseldorf in March 1999 against ViTec Audio und Video GmbH, a German company
that manufactures what the Company believes to be a video copy protection
circumvention device. ViTec filed a reply brief arguing that its product does
not infringe the Company's patents. The case was heard in the District Court of
Dusseldorf,
31
Germany. The District Court of Dusseldorf ruled adversely against the Company.
The Company appealed the District Court's ruling in July 2000 to the Court of
Appeal in Dusseldorf. A hearing took place in front of the Court of Appeal in
Dusseldorf on August 23, 2001 in which the Court stated that because the appeal
involves complex technical subject matter, the Court would require technical
expert witnesses. The Court selected Professor Dr. Ing. M. Plantholt as its
expert witness. On January 27, 2003, Professor Plantholt submitted his technical
opinion to the Court, and an English translation was made available to us on
July 3, 2003. We are reviewing the opinion and are considering our options. A
hearing before the Court of Appeal in Dusseldorf is scheduled for March 4, 2004.
In the event of an adverse ruling, the Company may incur a corresponding decline
in demand for its video copy protection technology, which could harm its
business in Germany. In addition, the Company may be obligated to pay some of
ViTec's attorney fees estimated to be US$25,000.
KRYPTON CO., LTD. V. MACROVISION CORPORATION
Krypton Co., Ltd., a Japanese company, filed an invalidation claim against
one of the Company's copy protection patents in Japan. After a hearing in March
1999, the Japanese Patent Office recommended that the Company's patent be
invalidated. On December 27, 1999, the Company appealed this decision to the
Tokyo High Court, and on March 21, 2000, the Tokyo High Court revoked the
Japanese Patent Office's decision. In connection with this ruling, the scope of
the Company's claims under the patent was slightly reduced, but this is not
expected to have a material adverse effect on the value of this patent to the
Company's business. In short, the patent remains valid and part of the Company's
business. On November 22, 2000, Krypton made an appeal in the Tokyo High Court
regarding its earlier decision. On March 3, 2003, the Tokyo High Court rejected
Krypton's arguments and reaffirmed its earlier decision. Krypton may appeal the
decision to the Japanese Supreme Court. Even if an adverse ruling ultimately
were reached on this invalidation claim, it would not have a material adverse
effect on the Company's business.
YIELD DYNAMICS, INC. V. MACROVISION CORPORATION AND GLOBETROTTER SOFTWARE, INC.
On October 17, 2002, Yield Dynamics, Inc. filed a federal court action in
the Northern District of California against the Company and Globetrotter
Software, Inc. Yield Dynamics alleges that it created a software interface to
allow its Genesis software product to work with our FLEXLM software and that the
Company distributed this code without Yield Dynamics' permission. Yield Dynamics
has asserted claims of copyright infringement, trade secret misappropriation,
common law unfair competition, and unfair competition under California's
Business and Professions Code. Yield Dynamics seeks an injunction, a
constructive trust on receipts from the licensing or sale of products containing
the interface code, and actual, compensatory and punitive damages. The Company
answered Yield Dynamic's complaint and has asserted a counterclaim for
declaratory relief. The action is currently in the final stages of discovery.
Although the Company does not expect a material adverse result, it is
unable to provide an estimate of the range or amount of potential loss in the
event of an adverse ruling. The Company intends to contest the case vigorously.
From time to time the Company has been involved in other disputes and legal
actions arising in the ordinary course of business. In management's opinion,
none of these other disputes and legal actions is expected to have a material
impact on the Company's consolidated financial position, results of operation or
cash flow.
As of June 30, 2003, it was not possible to estimate the liability, if any,
in connection with these matters. Accordingly, no accruals for these
contingencies have been recorded.
32
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company's Annual Meeting of Stockholders was held on May 27, 2003. The
following matters were voted on: (1) Election of Directors; (2) Amendment to the
ESPP; (3) Amendment to the Directors Plan; (4) Amendment to the 2000 Equity
Plan; (5) Approval of the Option Exchange Program; and (6) Appointment of
Auditors. The vote tally was as follows:
(1) Proposal to Elect Directors to Serve until the 2004 Annual Meeting of
Stockholders.
FOR WITHHOLD
-------------- ------------
John O. Ryan 34,384,115 9,968,015
William A. Krepick 43,367,016 985,114
Matthew Christiano 43,327,972 1,024,158
Donna S. Birks 42,263,066 2,089,064
William Stirlen 42,398,086 1,954,044
Thomas Wertheimer 42,435,586 1,916,544
Steven G. Blank 42,642,686 1,709,444
(2) Proposal to ratify the Amendment to the 1996 Employee Stock Purchase Plan to
Authorize the Issuance of an Additional 1,500,000 Shares and to Extend the Term
by an Additional 2 Years.
FOR AGAINST ABSTAIN
---------------- -------------- ----------------
34,132,919 2,054,234 245,244
(3) Proposal to ratify the Amendment to the 1996 Directors Stock Option Plan to
Authorize the Issuance of an Additional 275,000 Shares.
FOR AGAINST ABSTAIN
---------------- -------------- ----------------
28,699,645 7,458,492 274,260
(4) Proposal to ratify the Amendment to the 2000 Equity Incentive Plan to
Authorize the Issuance of an Additional 4,000,000 Shares to Eliminate the
Separate Limitation on Restricted Stock Awards.
FOR AGAINST ABSTAIN
---------------- -------------- ----------------
22,808,178 13,241,934 382,285
(5) Proposal to Approve the Option Exchange Program.
FOR AGAINST ABSTAIN
---------------- -------------- ----------------
37,542,353 6,456,009 371,768
33
(6) Proposal to Ratify the Appointment of KPMG, LLP as the Company's Auditors
for the Year Ending December 31, 2003.
FOR AGAINST ABSTAIN
---------------- -------------- ----------------
43,053,236 1,280,729 18,165
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
31.1 Rule 13a-14(a)/15d-14(a) Certification.
31.2 Rule 13a-14(a)/15d-14(a) Certification.
32.1 Section 1350 Certification.
32.2 Section 1350 Certification.
---------------------------------------------------------------------
(b) Reports on Form 8-K.
During the quarter ended June 30, 2003, the Company filed
three reports on Form 8-K. On April 24, 2003, the Company
reported on Form 8-K, under items 7 and 9, its press release
concerning a major license agreement with a significant
customer. On April 28, 2003, the Company reported on Form
8-K, under items 7, 9 and 12, its press release concerning
revenue and earnings results for the first quarter of 2003,
as well as revenue and earnings estimates for 2003. On May
16, 2003, the Company reported on Form 8-K, under items 7
and 9, its press release concerning the Company's continuing
relationship with a major customer.
34
SIGNATURES
In accordance with 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.
Macrovision Corporation
AUTHORIZED OFFICER:
Date: August 12, 2003 By: /s/ William A. Krepick
-------------------- ---------------------------------------
William A. Krepick
President and Chief Executive Officer
PRINCIPAL FINANCIAL OFFICER AND CHIEF ACCOUNTING OFFICER:
Date: August 12, 2003 By: /s/ Ian R. Halifax
-------------------- ---------------------------------------
Ian R. Halifax
Vice President, Finance and Administration,
Chief Financial Officer and Secretary
35