INTERVIDEO INC - 10-Q Quarterly Report

June 30,

2004

December 31,

2003

Account receivable from:

Customer C

Customer D

Customer E

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 Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

On July 31, 2004, the Registrant had 13,430,164 shares of common stock outstanding, $0.001 par value per share.

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these financial statements.

InterVideo, Inc. (“InterVideo” or the “Company”) is a provider of multimedia software products. These products span the digital video cycle by allowing users to capture, edit, author, distribute, burn and play digital video. The Company has historically derived a substantial majority of its revenue from sales of its WinDVD product, a software DVD player for personal computers (“PCs”) to PC original equipment manufacturers (“OEMs”). Other products include WinDVD Creator, InterVideo Home Theater, InterVideo DVD Copy and Linux-based versions of its DVD and DVR software designed for Linux-based PCs and consumer electronic (“CE”) devices and our InstantON technology. The Company’s software is bundled with products sold by PC OEMs. The Company sells its products to PC OEMs, CE manufacturers and PC peripherals manufacturers worldwide. In addition, the Company sells products through retail channels and directly to consumers through its websites.

The accompanying condensed consolidated financial statements include the accounts of InterVideo, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

The condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation of this interim information have been included.

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

Certain reclassifications have been made in the prior period’s financial statements to conform to the current presentation. Such reclassifications had no impact on previously reported results of operations.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company based its estimates and assumptions on historical experience and on various other assumptions believed to be applicable. The Company evaluates these estimates and assumptions on an on-going basis to ensure they remain reasonable under current conditions. Actual results could materially differ from these estimates.

The functional currency of the Company’s subsidiaries is the local currency. Accordingly, all assets and liabilities are translated into U.S. dollars at the current exchange rate at the applicable balance sheet date. Revenue and expenses are translated at the average exchange rate prevailing during the period. The effects of these translation adjustments are recorded in accumulated other comprehensive income as a separate component of stockholders’ equity. Exchange gains or losses arising from transactions denominated in a currency other than the functional currency of an entity are included in other income, net and have not been significant to the Company’s operating results in any periods presented.

The fair value of the Company’s cash, cash equivalents, short-term investments, long-term investments, accounts receivable and accounts payable approximate their respective carrying amounts due to their relatively short-term maturities.

The Company considers all highly liquid investments with an original maturity of three months or less, at the date of purchase, to be cash equivalents.

Short-term investments consist principally of United States treasury and federal agency notes, state and municipal notes/bonds, corporate bonds and certificates of deposit. The Company currently classifies all investment securities as available-for-sale. Securities classified as available-for-sale are required to be reported at fair value with unrealized gains and losses excluded from earnings and included in other comprehensive income.

Property and equipment are recorded at cost less accumulated depreciation or amortization. Depreciation is calculated using the straight-line method based on estimated useful lives of between three and seven years. Leasehold improvements are amortized over the lesser of the lease terms or the estimated useful lives of the improvements. Expenditures for maintenance and repairs are charged to expense as incurred. Cost and accumulated depreciation of assets sold or retired are removed from the respective property accounts, and the gain or loss is reflected in the condensed consolidated statements of income.

Other purchased intangible assets are recorded at cost less accumulated amortization. Amortization is computed on intangible assets with definite useful lives using the straight-line method over five years. Goodwill is not amortized but is tested for impairment, at least annually.

The Company from time to time acquires certain equity investments for the promotion of business and strategic objectives. Non-marketable equity investments are accounted for using the equity method if the Company has significant influence over the investee, or using the cost method, if the Company does not possess significant influence over the investee. Such investments are also subjected to periodic impairment review. As there are no liquid market to provide information for valuing such securities, the impairment analysis involves significant judgment on the part of management. Should the Company determine that a decline in the securities’ fair value that is considered to be other than temporary has occurred, the reduction in value is recorded as other non-operating expense.

The Company’s revenue is primarily derived from fees paid under software licenses granted to OEMs, distributors and directly to end users. The Company records revenue generated from these sales in accordance with SOP 97-2, “Software Revenue Recognition,” as amended, under which revenue is recognized when evidence of an arrangement exists, delivery of the software has occurred, the fee is fixed or determinable, and collectibility is probable.

Under the terms of the Company’s license agreements with the OEMs, the OEMs are entitled only to unspecified upgrades on a when and if available basis, prior to sell through to end users. Under the terms of the Company’s revenue recognition policy, the Company recognizes revenue based on evidence of products being sold by the OEMs. The Company does not have any obligation to provide upgrades to the OEMs’ customers. Accordingly, the Company does not defer any revenue as the Company no longer has any obligations once an OEM’s products have been shipped to an end customer. Under certain other agreements, the Company defers the recognition of OEM revenue due to ongoing obligations in association with upgrade rights to end users or significant post-contract support (“PCS”) provided to end users. Depending on the specific contractual obligation, the Company recognizes this revenue over a period of one to three years.

Under the terms of the OEM license agreements, each OEM will qualify the Company’s software on its hardware and software configurations. Once the software has been qualified, the OEM will begin to ship products and report sales to the Company, at which point revenue will be recorded. The OEM will have the right to return the software prior to qualification. Once it has been shipped, most OEMs do not have a right of return. Based on the history of returns from our OEMs, we have determined that the risk of returns is not material . Therefore, the Company does not maintain a returns reserve related to OEM sales. Under the terms of the Company’s OEM license agreements, the OEM has certain inspection and acceptance rights. These rights lapse once the product has been qualified and the shipment reported to us. Therefore, these acceptance rights do not impact the amounts or timing of revenue recognition.

Most OEMs pay a license fee based on the number of copies of licensed software included in the products sold to their customers. These OEMs pay fees on a per-unit basis, and the Company records associated revenue when it receives notification of the OEMs’ sales of the licensed software to end users. The terms of the license agreements generally require the OEMs to notify the Company of sales of their products within 30 to 45 days after the end of the month or quarter in which the sales occur. As a result, the Company generally recognizes revenue in the month or quarter following the sale of the product to the OEMs’ customers.

A small number of OEMs that sell PC components place orders with the Company for a fixed quantity of units at a fixed price. In such cases, qualification of the Company’s product is not required, and these OEMs have no rights to upgrades or returns. The Company generally recognizes revenue upon shipment to these OEMs.

In addition to the per unit license fees discussed above, certain OEM agreements also include prepaid license fees and/or non-recurring engineering (“NRE”) service fees primarily for porting the Company’s software to the OEMs’ hardware and software configurations. The prepaid license fees are typically recognized based on either a straight-line amortization over the prepayment period or based on actual shipments, whichever is greater. The NRE service fees are recognized upon completion and acceptance of NRE service. However, some OEM agreements also provide the OEM with rights to free post contract support (“PCS”), including unspecified future software upgrades. PCS is typically not available to the OEMs’ end users. The Company has established vendor specific objective evidence (“VSOE”) of fair value for PCS for end customer support on a limited number of products sold to OEMs in Japan. On these arrangements, the Company uses the residual method to account for the allocation between the license revenue and the service revenue. The allocated license revenue is recognized in full upon delivery where the only undelivered element of the agreement is PCS, and the allocated PCS is recognized over the period of the PCS obligation. In all other agreements where we have sold PCS in which we have not been able to establish a VSOE of fair value for PCS or where there are additional undelivered elements such as NRE fees, the Company defers all of the revenue until the NRE services are accepted and the only undelivered element is PCS. Once the only undelivered element is PCS the Company will recognize the entire agreement over the PCS period.

End-user sales are made directly through the Company’s websites. The Company does not offer specified upgrade rights to any class of customer, and there are no unspecified upgrade rights associated with end-user sales. The Company recognizes revenue from sales through its websites upon delivery of product and the receipt of payment by means of an authorized credit card. End users who purchase our software from our websites have limited rights of return for products they have purchased in the previous 14 days, which we currently reserve for using a 30-day sales return reserve based upon historical return percentages.

Certain distributors and retailers, primarily in Japan, have limited rights to return product that was purchased in the previous six-months. These distributors have no rights to product upgrades. The Company generally recognizes revenue, net of contractually obligated return rights, upon shipment to these distributors and retailers. Other distributors and retailers, primarily in the United States and Europe, have unlimited rights of return. The Company generally recognizes revenue upon receipt of evidence that the distributors and retailers have sold the Company’s products through to end users.

Certain customer agreements call for the payment by the Company of marketing development funds, co-operative advertising fees, rebates or similar charges. The Company accounts for such fees as a reduction in revenue, unless there is an identifiable benefit and the fair value of the charges can be reasonably estimated. Commissions paid to third-party sales representatives are included in sales and marketing expenses.

Cost of revenue consists primarily of licensed royalties, expenses incurred to manufacture, package and distribute the Company’s software products, the amortization of developed technology and costs associated with end-user PCS. Licensed royalties consist of royalties paid or accrued for payment to third parties for technology incorporated into the Company’s products. In general, the amount of royalties depends on the number of the Company’s product units sold and the royalty rates associated with the third-party technology incorporated into those products.

End-user PCS costs include the costs associated with answering end-user customer inquires and providing telephone assistance to end users of the Company’s products. The Company does not defer the recognition of any revenue associated with sales to end users, because no upgrades are provided and PCS is provided within 90 days after the associated revenue is recognized. Certain product costs associated with sales through retailers are deferred until the corresponding revenue has been recognized.

Basic net income per share is calculated by dividing net income for the period by the weighted average common shares outstanding during the period, less shares subject to repurchase. Diluted net income per share is calculated by dividing the net income for the period by the weighted average shares outstanding, adjusted for all potential common shares, which include shares issuable upon the exercise of outstanding common stock options, convertible preferred stock and other contingent issuances of common stock to the extent these shares are dilutive.

A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per share is as follows (in thousands, except per share amounts):

The following are potential common shares not included in the denominator used in the dilutive net income per share calculation, because to do so would be antidilutive for the periods presented (in thousands):

The Company accounts for stock-based compensation to employees under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations, and the disclosure requirements SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”, an amendment of SFAS 123, “Accounting for Stock-Based Compensation.” No stock-based compensation expense is recorded for options granted for which the exercise price equals or exceeds the market price of the underlying stock on the date of grant in accordance with the provisions of APB 25.

The following table illustrates the effect on net income and net income per share had the Company applied the fair value recognition provisions of SFAS 123 to stock-based compensation to employees.

The weighted average fair values of options granted to employees in the three and six months ended June 30, 2004 and 2003 are summarized in the following table, and were estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:

Because the Black-Scholes option valuation model requires the input of subjective assumptions, the resulting pro forma compensation cost may not be representative of that to be expected in future periods. The Company used the minimum value method to determine the fair value of options granted prior to its initial filing of a registration statement for its Initial Public Offering (“IPO”) in January 2002. This method does not consider the expected volatility of the underlying stock, and is only available to non-public entities. Accordingly, the Company has used an estimated volatility factor of 90% for grants issued subsequent to the initial filing date of the registration statement and up to the completion of the Company’s IPO in July 2003. Subsequent to the IPO in July 2003, the volatility factor is adjusted to reflect the fluctuation of the Company’s stock price on the Nasdaq National Market.

In July 2003, the Company commenced its 2003 Employee Stock Purchase Plan (“ESPP”), which has an overlapping 24-month offering period, and includes four 6-month purchase periods. Purchases are to be made twice a year, in the months of May and November. The plan permits participants to purchase common stock at 85% of the lower of the fair market value of common stock at the beginning of an offering period, or at the end of purchase period, through payroll deductions of up to 15% of their eligible compensation. If the fair market value of common stock at the end of a purchase period is less than the fair market value at the beginning of the offering period, participants will be withdrawn from the current offering period following their purchase of shares on the purchase date and will be automatically re-enrolled in a new offering period. Participants may end their participation at any time during an offering period and will be refunded their payroll deductions to date.

The first ESPP offering period began in July 2003 and ended in April 2004. The weighted average fair value of each common stock purchase right was $5.29 for the three and six months ended June 30, 2004, estimated on the beginning of the offering period using the Black-Scholes option pricing model with the following assumptions:

The Company accounts for income taxes using the asset and liability method. Deferred income taxes are recognized by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits for which future realization is uncertain.

For the period ended June 30, 2004, the Company calculated its projected effective tax rate for the year ending December 31, 2004 to be 39%. This rate differs from the statutory federal rate of 35% primarily due to state taxes, net of federal benefit and difference between federal and foreign tax rates.

Comprehensive income is the total of net income and all other non-owner changes in stockholders’ equity. The Company’s components of other comprehensive income and loss are foreign currency translation adjustments and unrealized gain or loss on available-for-sale investments. Such amounts are excluded from net income and are reported in accumulated other comprehensive loss in the accompanying condensed consolidated financial statements.

The available-for-sale securities at June 30, 2004 have contractual maturities ranging from 2004 to 2007.

Other purchased intangible assets, net, consist of the following (in thousands):

The anticipated amortization schedule for the remaining years of other purchased intangible assets, net, is as follows (in thousands):

During the quarter ended June 30, 2004, the Company invested the following privately-held companies in Taiwan: Appro Photoelectron Inc. and Master Integrated Appliances Co., Ltd. The total cost of these investments was $1.7 million. These investments will be accounted for under the equity method of accounting because the Company has significant influence over the investees. The Company will record its proportionate share of the investee’s net income or loss on a one-quarter lag since it is not practical to obtain financial information from the investee prior to the issuance of the current quarter’s financial statements.

In the quarter ended June 30, 2004, the Company announced a stock repurchase program pursuant to which it may purchase up to $10 million or 700,000 shares, of its outstanding common stock from time to time. $2.6 million of common stock, or 200,200 shares were repurchased and retired in this quarter. The duration of the repurchase program is open-ended. Under the program, the Company could purchase shares of common stock through open market transactions at prices deemed appropriate by management. The timing and amount of repurchase transactions under this program depends on market conditions and corporate and regulatory considerations.

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is the chief executive officer of the Company.

The Company has one operating segment: multimedia software. The Company sells its products primarily through OEMs and to end users through the Company’s websites and through retail channels. Sales of licenses to the Company’s software occur in three geographic locations, namely the United States, Europe and Asia. International revenues are based on the country in which the customer is located.

The following is a summary of revenue by sales channel and geographic region (in thousands):

The following is a summary of tangible long-lived assets by geographic region (in thousands):

The following individual customers accounted for greater than 10% of revenue in any of the periods presented:

Customers with accounts receivable balances that were individually greater than 10% of total accounts receivable, before allowances for doubtful accounts, at any of the periods presented were:

The Company has received notices of claims, and may receive additional notices of claims in the future, regarding alleged infringements of third parties intellectual property rights. It is not possible to predict with certainty whether or not the Company will ultimately be successful in any of these legal matters. The Company may be required to pay license fees and damages or be prohibited from selling its products in the future if it is determined that its products infringe on patents owned by third parties.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis of Financial Condition and Results of Operation, as well as information contained in “Risk Factors” below and elsewhere in this Quarterly Report on Form 10-Q, contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors. These risks, uncertainties and other factors include, among others, those identified under “Risk Factors.” Forward-looking statements are generally written in the future tense and/or are preceded by words such as “will,” “may,” “should,” “could,” “expect,” “suggest,” “believe,” “anticipate,” “intend,” “plan,” or other similar words. Forward-looking statements contained in this Quarterly Report include, among others, statements regarding 1) research and development expenses, (2) sales and marketing expenses, (3) other operating and capital expenditures, (4) anticipated growth of operations, personnel and infrastructure, (5) exercise prices of future option grants, (6) the sufficiency of our capital resources, (7) future sources of revenue, (8) growth, decline and seasonality of revenue, (9) deferrals of revenue, (10) interest income, (11) competition and competitive pressures, (12) general market and economic outlook, (13) product sales and prices, (14) our ability to comply with public company reporting requirements (15) settlement of intellectual property claims, (16) stock based compensation expenses, (17) general and administrative expenses, and (18) the utility of certain products The Company disclaims any obligation to update information in any forward-looking statement.

We are a leading provider of DVD software. We have developed a technology platform from which we have created a broad suite of integrated multimedia software products. These products span the digital video cycle by allowing users to capture, edit, author, distribute, burn and play digital video. We began operations in 1998 and shipped our first products in 1999. We sell our products to PC OEM’s, consumer electronics (“CE”) manufacturers and PC peripherals manufacturers worldwide and offer our software in up to 27 languages. We derive revenue primarily from the sale of software licenses to OEMs, which install our software onto PCs prior to delivery to customers. In addition, we derive revenue from the license of our software to CE manufacturers and manufacturers of PC peripherals that incorporate our software into their own products for distribution. We also sell our software through retail channels and directly to end users through our websites.

Historically, sales of our WinDVD product, a software DVD player for PCs, to PC OEMs have accounted for a substantial majority of our revenue. We derived 73% of our revenue for the three months ended June 30, 2004 from sales of our WinDVD product, primarily to PC OEMs, as compared to 78% and 83% of our revenue in the three months ended March 31, 2004 and June 30, 2003, respectively. For the six months ended June 30, 2004 and June 30, 2003, WinDVD product sales accounted for 76% and 84% of revenue, respectively. We expect that revenue from sales of our WinDVD product to PC OEMs will continue to account for a substantial majority of our revenue. In the future, we expect to derive an increasing percentage of our revenue from sales of other products including WinDVD Creator, InstantON, InterVideo Home Theater, InterVideo DVD Copy and Linux-based versions of our DVD and DVR software designed for Linux-based PCs and CE devices, and products sold through our retail and web-based sales channels.

Our software is generally bundled with products sold by PC OEMs. Our PC OEM customers include, among others, Dell, Fujitsu, Fujitsu Siemens, Hewlett-Packard, IBM, Sony and Toshiba. Due to a concentration in the PC OEM industry, we derive a substantial portion of our revenue from a small number of customers. For the three and six months ended June 30, 2004, our two largest customers accounted for 37% and 35% of our revenue, respectively, with Hewlett-Packard accounting for 24% and 22% of our revenue, respectively, and Toshiba accounting for 13% of our revenue in both periods. We expect that the revenue from Dell, which accounted for 6% and 8% of our revenue during the three and six months ended June 30, 2004, respectively, may decrease to $0 in future periods because our current portion of their business is moving to one of our competitors. If we are unable to replace this lost revenue with revenue from other customers or other sources, our revenue growth rate may slow or even decline. We expect that a small number of customers will continue to account for a majority of our revenue and gross profit for the foreseeable future, although the identity of those customers may change from period to period. Because there is only a limited number of potential new, large PC OEM customers for our WinDVD product, we must derive any future revenue growth principally from increased sales of WinDVD or other products to existing PC OEMs, CE manufacturers, PC peripherals manufacturers, smaller PC OEMs and to consumers

through retail channels and our websites. Because some of these other revenue opportunities are more fragmented than the PC OEM market and will require more time and effort to penetrate, our revenue may grow at a slower rate than in prior periods.

Shortly after the end of the second quarter, we signed a technology agreement with Microsoft Corporation whereby we have agreed to supply them with our DVD playback software for use in future products.

Historically, prices for our products have declined because of competition from other software providers, competition in the PC industry and diminishing margins experienced by PC OEMs as a result of decreased selling prices and periodic declines in unit sales. Accordingly, we have reduced the prices we charge PC OEMs for our WinDVD product, and expect such price reductions will continue in the future. As a matter of policy, we evaluate such price reductions on a continual basis and, in certain circumstances, may determine it will not be in the best interests of the Company to reduce prices below a certain level. We may decide not to lower our product prices, even if a loss of revenue would result. As a result of these declining prices, it may be more difficult for us to increase or maintain our revenue levels and may cause a decline in our gross profits even if our WinDVD and other product unit sales increase.

In 2000, we launched an Internet commerce sales initiative that allows users to purchase products from our websites. We also continue to expand our retail channels. For the three months ended June 30, 2004 and June 30, 2003, we derived 16% of our revenue from web and retail sales and for the six months ended June 30, 2004 and June 30, 2003, we derived 16% and 17% of our revenue from web and retail sales, respectively. To increase our web and retail sales in the future, we intend to increase investments in associated selling and marketing, capital equipment and research and development. The gross profits associated with our products sold through our websites are generally higher than those associated with our OEM sales. Accordingly, fluctuations in our web and retail revenue as a percentage of total revenue will impact our gross profits.

We derive and expect to continue to derive a significant portion of our revenue from sales outside of the United States. Sales outside of the United States accounted for 49% and 48% of our revenue for the three and six months ended June 30, 2004, respectively, as compared to 46% and 44% in the three and six months ended June 30, 2003, respectively. Currently, most of our international sales are denominated in U.S. dollars. Therefore, a strengthening dollar could make our products less competitive in foreign markets. Our current distribution agreements shift foreign exchange risk to our foreign distributors. We do not use derivative instruments to hedge foreign exchange risk. In the future, an increasing portion of our international revenue and expense may be denominated in foreign currencies.

Our financial condition and results of operations are likely to be affected by seasonality in the future. Historically, PC OEMs have experienced their highest volume of sales during the year-end holiday season. Because of the timing of our recognition of revenue associated with the sale of our products to OEMs, we expect this seasonality to have a positive effect on our revenue and operating income in the first quarter of each calendar year and a negative effect on our revenue and operating income in the second quarter of that year.

We base the discussions and analysis of our financial condition and results of operations upon our condensed consolidated financial statements, which we prepare in accordance with accounting principles generally accepted in the United States of America. In preparing these financial statements, we must 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 ongoing basis, we evaluate our estimates based on historical experiences and various other assumptions we believe are reasonable under the circumstances. Our actual results may differ from these estimates.

The accounting policies that most frequently require us to make estimates and judgments, and therefore are critical to understanding the results of our operations are:

Our revenue is primarily derived from fees paid under software licenses granted to PC OEMs, CE manufacturers, PC peripherals manufacturers, retail distributors, retail customers and directly to end users. We record revenue generated from these sales in accordance with SOP 97-2, “Software Revenue Recognition,” as amended, under which revenue is recognized when:

Typically, under the terms of our license agreements with our OEM customers, they are entitled only to unspecified upgrades on a when and if available basis, prior to sell through to end users. Under the terms of our revenue recognition policy, we recognize revenue based on evidence of products being sold by the OEMs to end users. We do not typically provide upgrades to the OEMs’ customers. Accordingly, under such agreements we do not defer any revenue, as we no longer have an obligation once an OEM’s products have been shipped to an end customer. Under certain other agreements, we defer the recognition of OEM revenue due to ongoing obligations in association with upgrade rights to end users or significant post-contract support (“PCS”) provided to end users. Depending on the specific contractual obligation, we recognize this revenue over a period of one to three years.

Under the terms of the OEM license agreements, each OEM will qualify the Company’s software on their hardware and software configurations. Once the software has been qualified, the OEM will begin shipping products and report sales to the Company, at which point revenue will be recorded. The terms of the license agreements generally require the OEM to notify us of sales of our products within 30 to 45 days after the end of a given month or quarter in which the sales occur. As a result, we generally recognize revenue in the month or quarter following the sale of the product to these OEM customers.

The OEM will have the right to return the software prior to qualification. Once product has been shipped, most OEMs do not have a right of return. Based on the history of returns from our OEM license agreements that allow for some right of return, we have determined that the risk of return is immaterial. Therefore, the Company does not maintain a returns reserve related to OEM sales. Under the terms of the Company’s OEM license agreements, the OEM has certain inspection and acceptance rights. These rights lapse once the product has been qualified and shipments are reported to us. As a result, these acceptance rights do not impact the amounts or timing of revenue recognition.

A small number of OEMs that sell PC components, place orders with us for a fixed quantity of units at a fixed price. In such cases, qualification of our products is not required, and these OEMs have no rights to upgrades or returns. We generally recognize revenue upon shipment to these OEMs.

In addition to the per unit license fees discussed above, certain OEM agreements also include prepaid license fees and/or non-recurring engineering (“NRE”) service fees primarily for porting our software to the OEM’s hardware and software configurations. The prepaid license fees are typically recognized based on either a straight-line amortization over the prepayment period or based on actual shipments, whichever is greater. The NRE service fees are recognized upon completion and acceptance of the NRE service. However, some OEM agreements also provide the OEM with rights to free PCS, including unspecified future software upgrades. We have established vendor specific objective evidence (“VSOE”) of fair value for PCS for end customer support on a limited number of products sold to OEMs in Japan. On these arrangements, we use the residual method to account for the allocation between the license revenue and the service revenue. The allocated license revenue is recognized in full upon delivery where the only undelivered element of the agreement is PCS, and the allocated PCS is recognized over the period of the PCS obligation. In all other agreements where we have sold PCS in which we have not been able to establish a VSOE of fair value for PCS or where there are additional undelivered elements, such as NRE fees, we defer all of the revenue until the NRE services are accepted and the only undelivered element is PCS. Once the only undelivered element is PCS, we will recognize the entire agreement over the PCS period.

End-user sales are made directly through our websites. We do not offer specified upgrade rights to any class of customer, and there are no unspecified upgrade rights associated with end-user sales. We recognize revenue from sales through our websites upon delivery of product and the receipt of payment by means of an authorized credit card. End users who purchase our software from our websites have limited rights of return for products they have purchased in the previous 14 days, which we currently reserve for using a 30-day sales return reserve based upon historical return percentages.

Certain distributors and retailers, primarily in Japan, have limited rights to return products that were purchased in the previous six months. These distributors have no rights to product upgrades. We generally recognize revenue, net of contractually obligated return rights, upon shipment to these distributors and retailers. Other distributors and retailers, primarily in the United States and Europe, have unlimited rights of return. We generally recognize revenue upon receipt of evidence that the distributors and retailers have sold our products through to end users.

Certain customer agreements call for the payment by us of marketing development funds, co-operative advertising fees, rebates or similar charges. We account for such fees as a reduction in revenue unless there is an identifiable benefit and the fair value of the charges can be reasonably estimated. Commissions paid to third-party sales representatives are included in sales and marketing expenses.

In preparing our consolidated financial statements, we assess the likelihood that our deferred tax assets will be realized from future taxable income. We establish a valuation allowance if we determine that it is more likely than not that some portion or all of the net deferred tax assets will not be realized. Changes in the valuation allowance are included in our consolidated statements of income as provision for income taxes. We exercise significant judgment in determining our provision for income taxes, our deferred tax assets and liabilities and our future taxable income for purposes of assessing our ability to utilize any future tax benefits from our deferred tax assets. If actual circumstances differ from our expectations, we may be required to adjust our estimates in future periods and our financial position, cash flows and results of operations could be materially affected.

Results of Operations – Comparison of the three and six months ended June 30, 2004 and 2003.

Revenue increased 28% to $16.7 million for the three months ended June 30, 2004 from $13.1 million for the three months ended June 30, 2003. OEM product sales increased 28% to $14.0 million for the three months ended June 30, 2004 from $10.9 million for the three months ended June 30, 2003 and accounted for approximately 84% of total revenue for both three-month periods. Web and retail sales increased 25% to $2.7 million for the three months ended June 30, 2004 from $2.2 million for the three months ended June 30, 2003. We derived a substantial portion of our revenue from a small number of customers. For the three months ended June 30, 2004, our two largest customers accounted for 37% of our revenue, with Hewlett-Packard accounting for 24% of our revenue and Toshiba accounting for 13% of our revenue. In the three months ended June 30, 2003 two customers accounted for 29% of our revenue with Hewlett-Packard accounting for 17% of our revenue and Dell accounting for 12% of our revenue. Sales outside the United States accounted for 49% of our revenue for the three months ended June 30, 2004 and 46% of our revenue for the three months ended June 30, 2003. The growth in revenue for the three months ended June 30, 2004 over the same period in the prior year reflects increased revenue from our WinDVD product sales of 12% and a sales increase of over 100% of our non-WinDVD products, which includes WinDVD Creator, WinCinema, WinDVR and InterVideo DVD Copy. This increase in revenue is largely the result of corresponding increases in shipment volumes for the respective products.

For the six months ended June 30, 2004 revenue increased 34% to $35.5 million as compared to $26.5 million for the six months ended June 30, 2003. This increase was partly attributable to our OEM product sales, which increased 35% to $29.8 million for the six months ended June 30, 2004 from $22.1 million for the six months ended June 30, 2003. Web and retail sales also increased 31% to $5.7 million for the six months ended June 30, 2004 from $4.4 million for the six months ended June 30, 2003. This overall revenue increase for the six months ended June 30, 2004 as compared with the six months ended June 30, 2003 reflects 21% growth in WinDVD product sales, nearly five times growth in WinDVD Creator product sales and 41% growth in our other product offerings. Also included in the six months ended June 30, 2004 is approximately $600,000 representing the recognition of previously deferred revenue as a result of changes in contractual agreements. We derived a substantial portion of our revenue from a small number of customers. For the six months ended June 30, 2004, our two largest customers accounted for 35% of our revenue, with Hewlett-Packard accounting for 22% of our revenue and Toshiba accounting for 13% of our revenue. In the six months ended June 30, 2003 two customers accounted for 30% of our revenue with Hewlett-Packard accounting for 19% of our revenue and Dell accounting for 11% of our revenue. Sales outside the United States accounted for 48% of our revenue for the six months ended June 30, 2004 and 44% of our revenue for the six months ended June 30, 2003.

Cost of revenue consists primarily of licensed royalties, expenses incurred to manufacture, package and distribute our software products, the amortization of developed technology and costs associated with end-user PCS. Licensed royalties consist of royalties paid or accrued for payment to third parties for technologies incorporated into our products. In general, the amount of royalties depends on the number of our product units sold and the royalty rates associated with the third-party technology incorporated into those products. End-user PCS costs include the costs associated with providing assistance to end users of our products. With the exception of packaging and distribution costs, the cost of revenue is generally the same for each product, regardless of sales channel.

Cost of revenue increased to $7.7 million, or 46% of revenue, for the three months ended June 30, 2004 from $5.4 million, or 41% of revenue, for the three months ended June 30, 2003. The increase in absolute dollars was primarily due to increased unit sales. The increase as a percentage of revenue was largely due to an overall decline in selling prices of our WinDVD products and an increase in per unit pricing of third party royalties paid to Dolby Laboratories. While we expect per unit pricing of third party royalties to remain relatively constant in the future, we expect cost of revenue to increase as unit sales increase.

For the six months ended June 30, 2004, cost of revenue increased 44% to $15.7 million as compared to $10.8 million for the six months ended June 30, 2003. The increase in absolute dollars was primarily due to increased unit sales. The increase as a percentage of revenue was largely due to an overall decline in selling prices of our WinDVD products and an increase in per unit pricing of third party royalties paid to Dolby Laboratories.

Gross profit is affected by competitive price pressures, fluctuations in unit volumes, changes in royalty amounts and changes in the mix of products sold and in our mix of distribution channels. Differences in the gross profits by sales channel are primarily a reflection of the pricing differences, which can be impacted by distribution and marketing rebates, associated with each sales channel. In addition, our gross profit may be affected by costs associated with the settlement of intellectual property matters. Gross profits were 54% of revenue for the three months ended June 30, 2004 as compared to 59% for the three months ended June 30, 2003. The decrease reflects lower average selling prices of our WinDVD products to our major OEM customers and an increase in per unit pricing of third party royalties paid to Dolby Laboratories, offset somewhat by an increase in revenues from other products that typically enjoy higher gross profits. Also affecting the gross profit amounts were delays in shipments by several of our OEM customers for our higher margin products, such as InstantON, and delays in the purchase of some higher margin products by our Asian OEM partners in the graphics card market due to, we believe, their transition to a new technology.

For the six months ended June 30, 2004, gross profits were $19.9 million or 56% of revenue as compared with $15.6 million or 59% of revenue for the six months ended June 30, 2003. The decrease reflects lower average selling prices of our WinDVD products to our major OEM customers without a proportional decrease in third party royalties and an increase in per unit pricing of third party royalties paid to Dolby Laboratories. Also affecting the gross profit amounts were delays in shipments by several of our OEM customers for our higher margin products, such as InstantON, and delays in the purchase of some higher margin products by our Asian OEM partners in the graphics card market due to, we believe, their transition to a new technology. Gross profits were positively impacted during the six months ended June 30, 2004 by the aforementioned recognition of approximately $600,000 of previously deferred revenue as a result of changes in contractual arrangements wherein the related product costs were recorded in an earlier period.

While our product mix is gradually shifting toward higher margin products, which we expect will have a favorable impact on gross profits, if our customers and partners continue to experience delays in the shipment of higher end and higher margin products our gross profits will continue to be adversely impacted.

Research and development expenses consist primarily of personnel and related costs, consulting expenses associated with the development of new products, technology license fees, professional fees and quality assurance and testing. Research and development expenses were $2.6 million, or 16% of revenue, for the three months ended June 30, 2004 and $1.9 million, or 15% of revenue, for the three months ended June 30, 2003. The increase in absolute dollars and as a percentage of revenue was primarily attributable to $161,000 in increased payroll and payroll related expenses due to increased research and development headcount in Taiwan and China, an increase of $204,000 of facilities and related costs mainly due to expanded operations in Taiwan and China, an increase in spending on outside consulting, professional services and related fees of $210,000 for the development of new technologies and an increase in other research and development operating expenses of $126,000.

For the six months ended June 30, 2004, research and development expenses were $4.9 million or 14% of revenue as compared with $3.6 million or 14% of revenue for the six months ended June 30, 2003. The increase in absolute dollars was primarily attributable to $493,000 in increased payroll and payroll related expenses due to increased research and development headcount in our Asian facilities, an increase of $369,000 of facilities and related costs mainly due to expanded operations in Asia, an increase in spending on outside consulting, professional services and related fees of $284,000 for the development of new and existing technologies and an increase other research and development operating expenses of $130,000.

We believe that a significant level of research and development expenses will be required to remain competitive, and, as a result, we expect these expenses to continue to increase in absolute dollars in the future.

Sales and marketing expenses consist primarily of personnel and related costs, including salaries and commissions, travel expenses, commissions paid to third party sales representatives and costs associated with trade shows, advertising and other marketing efforts. Sales and marketing expenses increased to $2.7 million, or 16% of revenue, for the three months ended June 30, 2004 from $2.1 million, or 16% of revenue, for the three months ended June 30, 2003. The increase was primarily attributable to $165,000 in increased payroll and payroll related expenses due to increased sales and marketing headcount, an increase in commissions of $108,000 due to increased retail activities, a $136,000 increase in public relations, promotional, tradeshow and travel expenses and an increase in other sales and marketing operating expenses of $184,000.

For the six months ended June 30, 2004, sales and marketing expenses were $5.5 million or 15% of revenue as compared to $4.4 million or 17% of revenue. The increase in absolute dollars was primarily attributable to $143,000 in increased payroll and payroll related expenses due to increased sales and marketing headcount, an increase in commissions of $256,000 due to increased retail activities, a $270,000 increase in facilities related expenses, a $255,000 increase in public relations, promotional, tradeshow and travel expenses and an increase in other sales and marketing operating expenses of $152,000. The decrease as a percentage of revenue is mainly attributable to the increase in revenue for the period while expenses incurred for sales and marketing activities did not increase proportionately.

We intend to actively market, sell and promote our products and take actions to further develop our brand name and retail presence. Therefore, we expect sales and marketing expenses to increase in absolute dollars in the future as we seek to further establish our retail presence.

General and administrative expenses consist primarily of personnel and related costs, support costs for finance, human resources, legal, operations, information systems and administration departments and professional fees. General and administrative expenses increased to $2.0 million, or 12% of revenue, for the three months ended June 30, 2004 from $901,000, or 7% of revenue, for the three months ended June 30, 2003. This increase in absolute dollars and as a percentage of revenue was primarily due to increases in payroll and payroll related expenses of $185,000, directors’ and officers’ liability insurance premiums of $125,000, an increase in outside consulting fees of $364,000 primarily due to Sarbanes-Oxley compliance efforts, increased audit, legal and other professional fees of $225,000, increased investor relations expenses and Board of Directors fees of $97,000 which are all related to our status as a publicly traded company and increased travel and other operating expenses of $78,000.

For the six months ended June 30, 2004, general and administrative expenses were $3.7 million or 10% of revenue as compared to $1.9 million or 7% of revenue. The increase in absolute dollars and as a percentage of revenue was primarily attributable to $439,000 in increased payroll and payroll related expenses due to increased headcount and the implementation of a company-wide bonus plan, directors’ and officers’ liability insurance premiums of $250,000, an increase in outside consulting fees of $522,000 primarily due to Sarbanes-Oxley compliance efforts, increased audit, legal and other professional fees, of $355,000, increased investor relations expenses and Board of Directors fees of $160,000 which are all related to our status as a publicly traded company and increased travel and other operating expenses of $100,000.

We expect general and administrative expenses to increase in absolute dollars as we build our infrastructure to support our anticipated growth and operations as a public company although we expect these increases will be offset somewhat as our expenses related to Sarbanes Oxley compliance decrease later this year and next.

Deferred stock-based compensation is recorded when options are granted with exercise prices less than the deemed fair market value of the underlying common stock. Stock-based compensation expenses are recognized as deferred stock-based compensation is amortized on an accelerated basis over the vesting period of the related options, which is generally four years. Stock-based compensation expenses decreased to $74,000 for the three months ended June 30, 2004 from $217,000 for the three months ended June 30, 2003.

For the six months ended June 30, 2004, stock-based compensation expenses decreased to $149,000 from $550,000 for the six months ended June 30, 2003.

In 2004, we continued to grant our stock options at exercise prices equal to the fair market value of our common stock on the date of grant, and therefore no additional deferred stock-based compensation has been recorded. Accordingly, we expect stock-based compensation expenses to continue to decrease through 2004.

Other income, net consists primarily of interest earned on our cash and cash equivalent balances, offset by other expenses. Other income, net increased to $262,000 for the three months ended June 30, 2004 from $75,000 for the three months ended June 30, 2003. For the six months ended June 30, 2004, other income, net increased to $435,000 from $163,000 for the six months ended June 30, 2003. This increase is primarily due to the interest earned on the additional cash generated from our initial public offering in July 2003.

We recorded a provision for income taxes of $747,000 for the three months ended June 30, 2004 as compared to $1.1 million for the three months ended June 30, 2003. Our effective tax rate was approximately 40% for the three months ended June 30, 2004. The effective tax rate for the three months ended June 30, 2003 was also 40%. For the six months ended June 30, 2004 we recorded a provision for income taxes of $2.4 million as compared to $2.2 million for the six months ended June 30, 2003. The effective tax rate for the six months ended June 30, 2004 was 39% as compared to 41% for the six months ended June 30, 2003. The effective tax rates for the three and six months ended June 30, 2003 did not reflect the tax benefit derived from the extraterritorial income (“ETI”).

During the six months ended June 30, 2004, cash, cash equivalents and short-term investments increased by $536,000 to $70.3 million, representing 77% of our total assets. Our cash, cash equivalents and short-term investments totaled $69.7 million at December 31, 2003 and represented 79% of our total assets. Cash and cash equivalents are highly liquid investments with an original maturity of 90 days or less at the date of purchase. Short-term investments consist principally of US treasury and federal agency notes, state and municipal notes/bonds, corporate bonds and certificates of deposit.

Net cash provided by operating activities was $4.5 million for the six months ended June 30, 2004. Net income of $3.7 million was adjusted for depreciation and amortization of $663,000, stock-based compensation of $149,000, decreases

in prepaid expenses and other assets of $538,000, increases in accrued liabilities and taxes payable of $528,000 and deferred revenue of $655,000. This was partially offset by deferred taxes and the provision for doubtful accounts of $240,000 an increase in accounts receivable of $1.5 million and a decrease in accounts payable of $122,000. The increase in accounts receivable is primarily due to increased shipment activity in the retail sector as well as changes in payment cycles with certain customers. The decrease in prepaid expenses and other current assets is mainly due to the amortization of prepaid directors and officers insurance and prepaid licenses and royalties. Net cash provided by operating activities was $2.1 million for the six months ended June 30, 2003. Net income of $3.2 million was adjusted for depreciation and amortization of $425,000, stock-based compensation of $550,000 and other non-cash charges and an increase in accounts payable of $263,000. This was offset by increases in accounts receivable of $414,000 and prepaid expenses and other current assets of $1.6 million and a decrease in accrued liabilities, taxes payable and deferred revenue of $226,000.

Net cash used in investing activities was $16.3 million for the six months ended June 30, 2004 due to purchases of short-term investments, net of by proceeds from maturities of short-term investments, of $13.9 million and purchases of property and equipment of $664,000 which was largely attributable to the implementation of our new ERP system, and expanded operations in Asia. Additionally, we invested $1.7 million in two private companies in Taiwan. Net cash used in investing activities was $832,000 for the six months ended June 30, 2003 due to purchases of short-term investments and property and equipment.

Cash used in financing activities was $1.4 million for the six months ended June 30, 2004 as a result of $2.6 million used for the repurchase of common stock offset by $1.2 million in proceeds from the issuance of common stock under our stock option and employee stock purchase plans. Cash provided by financing activities for the six months ended June 30, 2003 was $23,000 from proceeds from the issuance of common stock under our stock option plans.

In the quarter ended June 30, 2004, we announced a stock repurchase program pursuant to which we may purchase up to $10 million or 700,000 shares, of our outstanding common stock from time to time. $2.6 million of common stock was repurchased in this quarter, as mentioned above. The duration of the repurchase program is open-ended. Under the program, we could purchase shares of common stock through open market transactions at prices deemed appropriate by management. The timing and amount of repurchase transactions under this program depends on market conditions and corporate and regulatory considerations. For further details of the stock repurchase program, refer to Part II, Item 2 of this 10-Q report.

We currently have no significant commitments for capital expenditures. We anticipate that we will increase our capital expenditures consistent with our anticipated growth in personnel and infrastructure, including facilities and systems.

We currently have no debt obligations and we have no other significant fixed contractual obligations or commercial commitments that are not already accrued for in our financial statements. There have been no significant changes in operating leases since December 31, 2003.

We believe that our existing cash, cash equivalents and short-term investments will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. To the extent that our existing sources of cash and cash flow from operations are not sufficient to fund our activities, we will need to raise additional funds. If we raise funds through debt financing, we will have to pay interest and may be subject to restrictive covenants, which could limit our ability to take advantage of future opportunities or respond to competitive pressures or unanticipated industry changes. If we raise funds through an equity financing, it may have a dilutive effect on our existing stockholders. Additional financing may not be available when needed and, even if such financing is available, it may not be available on terms acceptable to us. In addition, although we have no present understandings, commitments or agreements with respect to any acquisitions of other businesses, services, products or technologies, we may from time to time evaluate potential acquisitions. These acquisitions may increase our capital requirements and reduce your percentage ownership in us.

As of June 30, 2004, we had no off balance sheet arrangements as defined in Item 303(a)(4) of the Securities and Exchange Commission’s Regulation S-K.

We are subject to a number of risks. Some of these risks are endemic to the DVD software industry and are the same or similar to those disclosed in our previous SEC filings. The fact that certain risks are endemic to the industry does not lessen the significance of these risks. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that we are unaware of, or that we may currently deem immaterial, may become important factors that harm our business. If any of the following risks actually occurs, our business could be harmed. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment. You should carefully consider each of the Risk Factors and the other information in this Quarterly Report.

The rapidly evolving nature of our industry makes it difficult to forecast our future results.

The market for our products is characterized by rapid changes in technology. Demand for our products depends on our ability to maintain competitive pricing and to provide new or improved products that keep up with changes in technology. Any evaluation of our business and prospects must be made in light of the risks and difficulties encountered by companies offering products or services in new and rapidly evolving markets. The market for software-based digital video and audio solutions for incorporation in products in the PC and consumer electronics industries is rapidly evolving, and it is difficult to forecast the future growth rate, if any, or size of the market for our products. We may not accurately forecast customer behavior and recognize or respond to emerging trends, changing preferences or competitive factors facing us, and, therefore, we may fail to make accurate financial forecasts. Our current and future expense levels are based largely on our investment plans and estimates of future revenue and are, to a large extent, fixed. As a result, we may be unable to adjust our spending in a timely manner to compensate for any unexpected revenue shortfall, which would harm our operating results.

We expect our operating results to fluctuate on an annual and quarterly basis, which may result in volatility of our stock price.

We expect our operating results to fluctuate on an annual and quarterly basis, which may cause our stock price to be volatile. Important factors, many of which are outside our control, that could cause our operating results to fluctuate include:

Due to these and other factors, period-to-period comparisons of our operating results may not be meaningful, and you should not rely on our results for any one period as an indication of our future performance. In addition, our future operating results may fall below the expectations of public market analysts or investors. In this event, our stock price could decline significantly.

Changes in our product and service offerings could cause us to defer the recognition of revenue, which could harm our operating results and adversely impact our ability to forecast revenue.

We have created, and intend to continue to create, new software and software bundles such as WinDVD Creator, InterVideo Home Theater, InterVideo DVD Copy and InstantOn. These products contain advanced features and functionality that have required and may continue to require us to provide an increased level of end-user support. In the future, as these new products become more complex, we may also be obligated to provide additional support to our OEM customers to bundle our software with their products. These potential increases in OEM and end-user support obligations could require us to defer both license and PCS revenues to future periods, which could harm our operating results and adversely impact our ability to accurately forecast revenue.

We expect our product prices to decline, which could harm our operating results.

We expect prices for our products to decline over the next few years. Because of competition from other software providers, competition in the PC industry and diminishing margins experienced by PC OEMs as a result of decreased selling prices and lower unit sales, we have reduced the prices we charge PC OEMs for our WinDVD product. We expect this trend to continue, which will make it more difficult to increase or maintain our revenue and may cause a decline in our gross profits, even if our WinDVD unit sales increase. If unit sale increases do not offset anticipated price declines, our revenue will decline. Accordingly, our future success will depend in part on our ability to introduce and sell new products and upgrades to our existing products, which could increase our revenue and could improve our profit margins.

We have a history of losses, and we may not sustain profitability on a quarterly or annual basis.

We did not achieve profitability until our fiscal year ended December 31, 2002. As of June 30, 2004, we had retained earnings of $1.4 million. We expect to incur significant operating expenses over the next several years in connection with the continued development and expansion of our business. Our expenses include research and development and marketing expenses relating to products that will not be introduced and will not generate revenue until later periods, if at all. We may not sustain or increase profitability on a quarterly or annual basis in the future.

We have received notices of claims, and may receive additional notices of claims in the future, regarding the alleged infringement of third parties’ intellectual property rights that may result in restrictions or prohibitions on the sale of our products and cause us to pay license fees and damages.

Some third parties hold patents that such parties claim cover various aspects of DVD technology incorporated into our and our customers’ products.

Our digital video and audio products comply with industry standard DVD specifications. Some third parties have claimed that various aspects of DVD technology incorporated into our and our customers’ products infringe upon patents held by them, including the following:

We and our customers may be subject to additional third-party claims that our and our customers’ products violate the intellectual property rights of those parties.

In addition to the claims described above, we may receive notices of claims of infringement of other parties’ proprietary rights. Many companies aggressively use their patent portfolios to bring infringement claims against competitors and other parties. As a result, we may become a party to litigation in the future as a result of an alleged infringement of the intellectual property rights of others, including DVD 6C or Nissim. In addition, we are aware that a consortium of companies, known as “4C,” has been formed for the purpose of asserting the patent rights of its members covering some aspects of DVD technology. 4C may demand that PC OEMs or other companies manufacturing or licensing DVD-related products, including us and our customers, pay license fees and damages for the use of the technology, or be prohibited from selling products, covered by the 4C patents. Similarly, other parties have alleged that aspects of MPEG-2 and other multimedia technologies infringe upon patents held by them. We may be required to pay license fees and damages or be prohibited from selling our products in the future if it is determined that our products infringe on patents owned by these third parties. In addition, other companies may form consortia in the future, similar to MPEG LA, DVD 6C and 4C, to enforce their proprietary rights and these consortia may seek to enforce their patent rights against us and our customers. Some of our products can be used in connection with the copying of video content, which may include content protected by copyright. Though we believe these products do not contribute to copyright infringement and do not defeat encryption in violation of the Digital Millennium Copyright Act, some content owners have shown a willingness to instigate litigation against producers of products that could be used to copy copyrighted content. Defending such suits could be costly and could cause a serious disruption in our business regardless of the outcome.

We may be required to pay substantial damages and may be restricted or prohibited from selling our products if it is proven that we violate the intellectual property rights of others.

If DVD 6C, 4C, Nissim or another third party proves that our technology infringes its patents, we may be required to pay substantial damages for past infringement and may be required to pay license fees or royalties on future sales of our products. If we are required to pay license fees in the amounts that are currently published by, for example, DVD 6C for past sales to our large PC OEM customers, such fees would exceed the revenue we have received from those PC OEM customers. In addition, if it were proven that we willfully infringed on a third party’s patents, we may be held liable for

three times the amount of damages we would otherwise have to pay. In addition, intellectual property litigation may require us to:

Furthermore, the defense of infringement claims and lawsuits, regardless of their outcome, would likely be expensive to resolve and could require a significant portion of management’s time. In addition, rather than litigating an infringement matter, we may determine that it is in our best interests to settle the matter. Terms of a settlement may include restrictions or prohibitions on our ability to sell products incorporating the other party’s technology, the payment of damages and our agreement to license technology in exchange for a license fee and ongoing royalties. These fees may be substantial. If we are forced to take any of the actions described above, defend against any claims from third parties or pay any license fees or damages, our business could be harmed.

We may be liable to some of our customers for damages that they incur in connection with intellectual property claims.

Our license agreements, including the agreements we have entered into with our large PC OEM customers, generally contain warranties of non-infringement and commitments to indemnify our customers against liability arising from infringement of third-party intellectual property rights. Examples of third-party intellectual property rights include the patents held by Nissim and by members of MPEG LA, DVD 6C and 4C. These commitments may require us to indemnify or pay damages to our customers for all or a portion of any license fees or other damages, including attorneys’ fees, our customers are required to pay, or agree to pay, these or other third parties. We have received notices from some of our customers asserting that we are required to indemnify them under our agreements with them, or providing notice that they have received from third parties infringement claims that are related to our products. These customers include, among others, Micron Electronics and MPC LLC (formerly known as Micron PC LLC), as well as other customers with which we have settled. We may be required to make additional cash payments to settle similar claims in the future. Although MPEG LA has stated that some of our PC OEM customers, including Dell, Fujitsu Limited, Gateway, Hewlett-Packard, Sony and Toshiba, are currently MPEG LA licensees, not all of our PC OEM customers are MPEG LA licensees. Notwithstanding that we have signed a license agreement with MPEG LA, we may continue to be liable to some of our customers for amounts that those customers pay or have paid to MPEG LA in settlement of claims of infringement brought by MPEG LA against those customers. Even with respect to those PC OEM customers that have become licensees, we may have liability to these customers for prior infringement and future royalty payments. If we are required to pay damages to our customers or indemnify our customers for damages they incur, our business could be harmed. If our customers are required to pay license fees in the amounts that are currently published by some claimants, and we are required to pay damages to our customers or indemnify our customers for such amounts, such payments would exceed our revenue from these customers. Even if a particular claim falls outside of our indemnity or warranty obligations to our customers, our customers may be entitled to additional contractual remedies against us. Furthermore, even if we are not liable to our customers, our customers may attempt to pass on to us the cost of any license fees or damages owed to third parties by reducing the amounts they pay for our products. These price reductions could harm our business.

We license technology from third parties for use in our WinDVD and other standards-based products, and we might not be able to ship our products in their present forms if we fail to maintain these license arrangements.

We license technology for use in our WinDVD product, our WinRip product, our WinDVD Creator product, our WinRecorder product and other existing and planned products from third parties under agreements, some of which have a limited duration. For example, we have a license agreement with Dolby Laboratories for its audio technology and logo, a license agreement with the DVD Copy Control Association, Inc. for the content scrambling system designed to prevent the copying of DVDs, a license with MPEG-LA for its MPEG-2 video technology, a license from Thomson Licensing S.A. for its MP3 audio technology and various other license agreements relating to patents, know-how and trademarks that are important to various aspects of the development, marketing and sale of our products. We are obligated to pay royalties under each of the Dolby, DVD Copy Control Association, MPEG-LA and Thomson Licensing S.A. agreements, and Dolby, DVD Copy Control Association, MPEG LA and Thomson Licensing may each terminate its license if we breach any

material provision of the license or if other events occur, as specified in the license agreement. Recently, Dolby informed us of a royalty pricing increase planned the second quarter of 2004. Accordingly, even if we are able to maintain our licensing agreements with Dolby, we expect our gross profits to be adversely affected by increased royalty payments to Dolby. If we fail to maintain these license arrangements, we might not be able to ship our products in their present forms and our revenue could decline.

Because there is a small number of large PC OEMs, we have only a limited number of potential new large OEM customers for our WinDVD product, which will likely cause our revenue to grow at a slower rate than in recent periods.

Our revenue growth has been achieved in large part due to sales of our WinDVD product to new, large PC OEM customers. Because there is only a limited number of potential new, large PC OEM customers for our WinDVD product, we must derive any future revenue growth principally from increased sales of WinDVD or other products to existing PC OEMs and PC peripherals manufacturers and from sales to smaller regional PC OEMs and directly to consumers through retail channels and our websites. Because some of these other revenue opportunities are more fragmented than the PC OEM market and will take more time and effort to penetrate, we expect that our revenue will grow at a slower rate than in recent periods. Additionally, if the rate of such expansion via retail channels and our website proceeds slower than we anticipate, our financial position could be adversely affected.

We depend substantially on our relationships with a small number of PC OEMs, and our failure to maintain or expand these relationships would reduce our revenue and gross profit or otherwise harm our business.

The PC industry is highly concentrated, and we have derived a substantial portion of our revenue from sales of our products to a small number of PC OEMs. For the three and six months ended June 30, 2004, our two largest customers accounted for 37% and 35% of our revenue, respectively, with Hewlett-Packard accounting for 24% and 22% of our revenue, respectively, and Toshiba accounting for 13% of our revenue in both periods. We expect that the revenue from Dell, which accounted for 6% and 8% of our revenue during the three and six months ended June 30, 2004, respectively, may decrease to $0 in future periods because our current portion of their business is moving to one of our competitors. If we are unable to replace this lost revenue with revenue from other customers or other sources, our revenue growth rate may slow or even decline. One customer accounted for 22% of our accounts receivables balance as of June 30, 2004. While a substantial portion of this accounts receivable has been paid, we expect that a small number of customers will continue to account for a majority of our revenue, gross profit and accounts receivables for the foreseeable future because of the concentrated nature of our client base. If our customers dispute the accounts receivables or are otherwise unable to pay the balance, our income from operations could decline. If the PC industry continues to consolidate, the number of customers accounting for the majority of our revenue could decrease further. Our agreements with our customers typically do not contain minimum purchase commitments and are of limited duration or are terminable with little or no notice. The loss of any of these customers, or a material decrease in revenue from these customers, would reduce our gross profit or otherwise harm our business.

If our competitors offer our OEM customers more favorable terms than we do or if our competitors are able to take advantage of their existing relationships with these OEMs, then these OEMs may not include our software with their PCs. If we are unable to maintain or expand our relationships with PC OEMs, our business will suffer.

As a result of our dependency on a small number of large PC OEMs, any problems those customers experience, or their failure to promote products that contain our software, could harm our operating results.

As a result of our concentrated customer base, problems that our PC OEM customers experience could harm our operating results. Some of the factors that affect the business of our PC OEM customers, all of which are beyond our control, include:

The inability of our PC OEM customers to successfully address any of these risks could harm our business. In addition, we have little or no influence over the degree to which these customers promote products that incorporate our software or the prices at which these products are sold to end users. If our PC OEM customers fail to adequately promote products that incorporate our software, our revenue could decline.

We have derived a substantial majority of our revenue from the sale of our WinDVD product to PC OEMs, and these customers may not continue to purchase this product or we may fail to attract new customers for this product.

We derived 73% of our revenue for the three months ended June 30, 2004 from sales of our WinDVD product, primarily to PC OEMs, as compared to 78% and 83% of our revenue in the three months ended March 31, 2004 and June 30, 2003, respectively. For the six months ended June 30, 2004 and June 30, 2003, WinDVD product sales accounted for 76% and 84% of revenue, respectively. We expect that revenue from sales of our WinDVD product to PC OEMs will continue to account for a substantial majority of our revenue for the foreseeable future. Accordingly, our business will suffer if our existing PC OEM customers do not continue to incorporate our WinDVD product into the PCs they sell or if we are unable to obtain new PC OEM customers for our WinDVD product.

Slow growth, or negative growth, in the PC industry could reduce demand for our products and reduce our gross profit.

Our revenue depends in large part on the demand for our products by PC OEMs. The PC industry has experienced slow or negative growth in the recent past due to a general economic slowdowns, market saturation and other factors. If slow or negative growth in the PC industry were to recur, demand for our products may decrease. Furthermore, if a reduction in demand for our products occurs, we may not be able to reduce expenses commensurately, due in part to the continuing need for research and development. Accordingly, continued slow growth or negative growth in the PC industry could reduce our gross profit.

Our success in generating revenue depends on the growth of the use of software solutions in the PC and consumer electronics industries.

Our continued success in generating revenue depends on growth in the use of software solutions to add features and functionality to PCs and CE devices. Our software is currently used primarily in PCs, and we expect it to be useful for CE products. These markets are rapidly evolving, and it is difficult to predict their potential size or future growth rate. In addition, we are uncertain as to the extent to which software products such as ours will be used in these markets in the future. Their market acceptance may be impacted by the performance, cost and availability of semiconductors that perform similar functions and the level of copy protection that can be attained and maintained in software products. Our success in generating revenue in these markets will depend on increased adoption of software solutions based on the same standards as ours. If the PC and consumer electronics markets adopt software solutions more slowly than we expect, or if content providers are dissatisfied with the level of copy protection available in software products, our growth would not likely continue, and our business would likely suffer.

Our products are based primarily on the Microsoft Windows operating system, and most of our customers require that the combination of our software products and their PCs be certified by Microsoft’s Windows Hardware Qualification Labs. Accordingly, we are dependent on Microsoft, which exposes us to risks, particularly if Microsoft chooses to compete with us in the future.

Our products are based primarily on the Microsoft Windows operating system. If industry and customer preferences in operating systems shift, our products may not be compatible with other operating systems and our business could be harmed.

Our revenue is highly dependent upon acceptance of products that are based on the Microsoft Windows operating system, which is currently the dominant operating system used in the PC industry. Microsoft could make changes to its operating system that could render our products incompatible. Other industry participants could develop operating systems to replace the Windows operating system, and our products might not be compatible with those operating systems. If our products are not compatible with one or more of the operating systems with significant PC market share, we could incur

substantial costs and expend significant capital and other resources to adapt our products to one or more operating systems. There is no assurance that we would be able to adapt our products to changes made in the Windows operating system in the future or to a new operating system, and any failure to adapt to changes in operating systems by the PC industry could result in significant harm to our business.

Most of our customers require that the combination of our software products and their PCs be certified by Microsoft’s Windows Hardware Qualification Labs. If certification is not obtained, our revenue could decline or our customers may license a competitor’s software.

We sell most of our products through PC OEMs, which bundle our products with their hardware products. Most of our PC OEM customers require Microsoft’s Windows Hardware Qualifications Labs, or WHQL, certification for our products on each PC platform before bundling and distribution. The certification process is entirely under Microsoft’s control, and we may not obtain certification for any product on a timely basis or at all. Furthermore, Microsoft may change the requirements for certification at any time without notice. At various times in the past, Microsoft has changed standards applicable to our products, which caused us to be out of compliance for a period of time. In the future, we may not be able to obtain necessary certification on a timely basis, if at all, for new PC models introduced by our customers, for any of our products under development or for existing products, if the current standards are changed. Any delays in receipt of, or failure to receive, such certification could cause our revenue to decline or our customers to license a competitor’s software.

If Microsoft develops or licenses digital video and audio solutions that compete directly with ours, our business could suffer.

Microsoft currently offers products in the digital video and audio software markets. Some video and audio capabilities are built directly into their operating systems or are offered as upgrades to those operating systems at no additional charge. If Microsoft develops or licenses digital video and audio solutions that compete directly with ours and incorporates the solutions into its operating system, or otherwise changes its operating system or its Windows Hardware Qualification Labs standards to render our products incompatible, our business could be harmed.

Competition in our industry is intense and is likely to continue to increase, which could result in price reductions, decreased customer orders, reduced product margins and loss of market share, any of which could harm our business.

Our industry is intensely competitive, and we expect competition to intensify in the future. Our competitors include:

Our primary competitors are Adobe Systems Incorporated, Cyberlink Corporation, Pinnacle Systems, Inc., Roxio, Inc., Sonic Solutions, Inc. and Ulead Systems, Inc. Additional competitors are likely to enter our industry in the future. We also face competition from the internal research and development departments of other software companies and PC and CE manufacturers, including some of our current customers. Some of our customers have the capability to integrate their operations vertically by developing their own software-based digital and audio solutions or by acquiring our competitors or the rights to develop competitive products or technologies, which may allow these customers to reduce their purchases or cease purchasing from us completely. Operating system providers with an established customer base, such as Microsoft, already offer products in the digital video and audio software markets. Some video and audio capabilities are built directly into their operating systems or are offered as upgrades to those operating systems at no additional charge. If Microsoft or other operating system providers develop or license digital video and audio solutions that compete directly with ours and incorporate the solutions into their operating systems, our products could lose market share.

We expect our current competitors to introduce similar or improved products at lower prices, and we will need to do the same to remain competitive. For example, we expect revenues from Dell to decline in successive quarters with the possibility of no revenue from Dell in the future periods, because our current portion of their business is moving to one of our competitors. We may not be able to compete successfully against either current or future competitors with respect to new or improved products. We believe that competitive pressures may result in price reductions, reduced margins and our loss of market share.

Many of our current competitors and potential competitors have longer operating histories and significantly greater financial, technical, sales and marketing resources or greater name recognition than we do. As a result, these competitors are able to devote greater resources to the development, promotion, sale and support of their products. In addition, our competitors that have large market capitalizations or cash reserves are in a better position to acquire other companies in order to gain new technologies or products that may displace our products. Any of these potential acquisitions could give our competitors a strategic advantage. In addition, some of our current competitors and potential competitors have greater brand name recognition, a more extensive customer base, more developed distribution channels and broader product offerings than we do. These companies can use their broader customer base and product offerings, or adopt aggressive pricing policies, to gain market share. Increased competition in the market may result in price reductions, decreased customer orders, reduced profit margins and loss of market share, any of which could harm our business.

If we do not provide acceptable customer support, our reputation will suffer and it will be difficult to retain existing customers or to acquire new customers.

We will need to continue to provide acceptable customer support to our customers. An inability to do so will harm our reputation and make it difficult to retain existing customers or acquire new customers. Most of our experience to date has been with corporate customers, some of which require significant support when familiarizing themselves with the features and functionality of our products. We intend to increase sales of our products directly to consumers. We have limited experience with widespread distribution of our products directly to consumers, and we may not have adequate experience or personnel to provide the levels of support that these customers require. Our failure to provide adequate customer support for our products to either our corporate or consumer customers could damage our reputation and brand in the marketplace and strain our relationships with customers. This could prevent us from retaining existing customers or acquiring new customers.

Our ability to achieve profitability will suffer if we fail to manage our growth effectively.

Our success depends on our ability to effectively manage the growth of our operations. We cannot be certain that our current cost structure is appropriate for the level of revenue that we generate. Furthermore, we expect to increase the scope of our operations in the future. To manage the growth of our operations and personnel, we will need to improve our operational and financial systems, procedures and controls as well as hire additional qualified personnel. Our current and planned systems, procedures and controls may not be adequate to support our future operations and expected growth. Delays or problems associated with any improvement or expansion of our operational systems and controls could harm our relationships with customers, reputation and brand.

We may lack the ability to record, process, summarize and report financial data in compliance with our public company reporting requirements if we fail to improve our internal controls and procedures for financial reporting.

In connection with the audit of our financial statements for the year ended December 31, 2003, our independent auditors advised management and the Audit Committee of the Board of Directors that it had identified a deficiency in internal controls that rose to the level of a reportable condition under standards established by the American Institute of Certified Public Accountants. Reportable conditions are matters that, in our auditors’ judgment, relate to significant deficiencies in the design or operation of our internal controls that could adversely affect our ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements. The reportable condition identified by our auditors relates to our internal controls over revenue recognition. During the quarter ended June 30, 2004 we implemented procedures and policies that we believe improves our ability to process and report accurate revenue numbers, and will remedy the reportable condition identified by our auditors. Our failure to continue to enforce these newly enacted procedures and policies may adversely affect our ability to record, process, summarize and report financial data in compliance with public company reporting requirements. Any failure to comply with public company reporting requirements could cause our stock price to decline.

The loss of any of our strategic relationships would make it more difficult to design competitive products and keep pace with evolving industry standards, which could reduce demand for our products and harm our business.

We must design our software products to interoperate effectively with a variety of hardware and software products, including operating system software, graphics chips, DVD drives, PCs and PC chipsets. We depend on strategic

relationships with software developers and manufacturers of these products, particularly Microsoft and Intel, to achieve our design objectives, to produce products that interoperate successfully, to provide us with information concerning customer preferences and evolving industry standards and trends, and to assist us in distributing our products to users. For example, we have been able to learn about future product lines being developed by some of our OEM customers in advance so that we were able to more efficiently design products that our customers, and the ultimate end users, find valuable. However, we generally do not have any agreements with these third parties to ensure that such information will be provided to us, and these relationships may not continue in the future. The loss of any one of these relationships could reduce demand for our products and harm our business.

Our products may have defects or may be incompatible with other software or components contained in our customers’ products, which could cause us to lose customers, damage our reputation and create substantial costs.

Defects, referred to in the software industry as “bugs,” have been found in our products in the past and may be found in the future. In addition, our products may fail to meet our customers’ design specifications or be incompatible with other software or components contained in our customers’ products, or our customers may change their design specifications or add additional third-party software or components after the production of our products. We may be required to devote significant financial resources and personnel to correct any defects. A failure to meet our customers’ design specification often results in a loss of sales due to the length of time required to redesign the product. Our products may also be required to interface with defective third-party software or components. If we are unable to detect or fix errors, or meet our customers’ design specifications, our business and results of operations would suffer.

We may experience seasonality in our business, which could cause our operating results to fluctuate.

The market for our products is new and constantly changing. If we do not respond to changes in a timely manner, our products likely will no longer be competitive.

The market for our products is characterized by rapid technological change, new and improved product introductions, changes in customer requirements and evolving industry standards. Our future success will depend to a substantial extent on our ability to develop, introduce and support cost-effective new products and technologies on a timely basis. If we fail to develop and deploy new cost-effective products and technologies or enhancements of existing products on a timely basis, or if we experience delays in the development, introduction or enhancement of our products and technologies, our products will no longer be competitive and our business will suffer. The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We may not be able to identify, develop, manufacture, market or support new or enhanced products on a timely basis, if at all. Furthermore, our new products may never gain market acceptance, and we may not be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards. Our failure to respond to product announcements, technological changes or changes in industry standards would likely prevent our products from gaining market acceptance and harm our business.

If we do not successfully establish strong brand identity in the PC and consumer electronics markets, we may be unable to achieve widespread acceptance of our products.

We believe that establishing and strengthening the InterVideo brand is critical to achieving widespread acceptance of our products and to establishing key strategic relationships. The importance of brand recognition will increase as current and potential competitors enter the market with competing products. Our ability to promote and position our brand depends largely on the success of our marketing efforts and our ability to provide high quality products and customer support. These activities are expensive and we may not generate a corresponding increase in customers or revenue to justify these costs. If we fail to establish and maintain our brand, or if our brand value is damaged or diluted, we may be unable to attract new customers and compete effectively. Historically, we have relied primarily on a limited direct sales force, supported by third-party

manufacturers’ representatives and distributors, to sell our products. Our sales strategy focuses primarily on our corporate customers bundling our products with their hardware and distributing our products through their own distribution channels. We rely on our customers’ sales forces, marketing budgets and brand images to promote sales of bundled products. If our corporate customers fail to successfully market and sell their products bundled with our products, or if our relationship with our corporate customers are terminated, we may be unable to effectively market and distribute our products and services.

We rely on patents, trademarks, copyrights, trade secrets and license agreements to protect our proprietary rights, which afford only limited protection.

Our success depends upon our ability to protect our proprietary rights. We rely on a combination of patent, copyright, trademark and trade secret laws, as well as license and confidentiality agreements with our employees, customers, strategic partners and others to establish and protect our proprietary rights. The protection of patentable inventions is important to our future opportunities. We currently have one issued U.S. patent and three patents issued in Taiwan, and we have 46 pending patent applications, comprised of 34 U.S. patent applications and 12 foreign patent applications. It is possible that:

Existing copyright, trademark and trade secret laws and license and confidentiality agreements afford only limited protection. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States, and policing the unauthorized use of our products is difficult. Any failure to adequately protect our proprietary rights could result in our competitors offering similar products, potentially resulting in the loss of some of our competitive advantage and a decrease in our revenue. Infringement claims and lawsuits would likely be expensive to resolve and would require management’s time and resources and, therefore, could harm our business.

Our success depends on retaining our key personnel, including our executive officers, the loss of any of whom could disrupt our operations or otherwise harm our business.

Our success depends on the continued contributions of our senior management and other key engineering, sales and marketing and operations personnel. Competition for employees in our industry can be intense. We do not have employment agreements with, or key man life insurance policies covering, any of our executives. In addition, significant portions of the capital stock and options held by the members of our management are vested, and some of our executives are parties to agreements that provide for the acceleration of the vesting of a portion of their unvested shares and options under certain circumstances in connection with a change of control. There can be no assurance that we will retain our key employees or be able to hire replacements. Our loss of any key employee or an inability to replace lost key employees and add new key employees as we grow could disrupt our operations or otherwise harm our business.

We rely on the accuracy of our customers’ sales reports for collecting and reporting revenue. If these reports are not accurate, our reported revenue will be inaccurate.

A substantial majority of our revenue is generated by our PC OEM customers that pay us a license fee based upon the number of copies of our software they bundle with the PCs that they sell. In collecting these fees, preparing our financial

reports, projections and budgets and in directing our sales efforts and product development, we rely on our customers to accurately report the number of units licensed. We have never audited any of our customers to verify the accuracy of their reports or payments. Most of our license agreements permit us to audit our customers, but audits are expensive and time consuming and could harm our customer relationships. From time to time, customers have provided us with inaccurate reports, which resulted in our under-reporting or over-reporting revenue for the associated period and recording an adjustment in a future period. If any of our customer reports are inaccurate, the revenue we collect and report will be inaccurate and we may be required to make an adjustment to our revenue for a subsequent period, which could harm our business and credibility in the financial community.

Our international operations accounted for 49% and 48% of our revenue for the three and six months ended June 30, 2004 and 46% and 44% of our revenue for the three and six months ended June 30, 2003, which may expose us to political, regulatory, economic, foreign exchange and operational risks.

Because we sell our products worldwide, our business is subject to risks associated with doing business internationally. We expect to continue to derive a significant portion of our revenue from international sales. We intend to expand our international operations in the future. Significant management attention and financial resources are needed to develop our international sales, support and distribution channels and manufacturing. We may not be able to maintain international market demand for our products. Our future results could be harmed by a variety of factors related to international operations, including:

Currently, most of our international sales are denominated in U.S. dollars. Therefore, a strengthening of the dollar could make our products less competitive in foreign markets. Our current distribution agreements shift foreign exchange risk to our foreign distributors. This exchange risk may harm the businesses of those distributors or make them less willing to carry and sell our products. We do not use derivative instruments to hedge foreign exchange risk. In the future, a portion of our international revenue and expenses may be denominated in foreign currencies. Accordingly, we could experience the risks of fluctuating currencies and may choose to engage in currency hedging activities. In addition, if we conduct sales in local currencies, we may engage in hedging activities, which may not be successful and could expose us to additional risks.

In addition, we and certain of our OEM customers maintain significant operations in Asia. Any kind of economic, political or environmental instability in this region of the world could harm our operating results. Further, we may be impacted by the political, economic and military instability in Taiwan, including potential international conflict arising from recent Taiwanese elections.

Our business and future operating results are subject to a broad range of uncertainties arising out of geopolitical developments in the Middle East and North Korea.

Our business and operating results are subject to uncertainties arising out of geopolitical developments in the Middle East and North Korea, including the U.S. actions in Iraq and the continuing political tension between the United States and

North Korea. These uncertainties include the potential worsening or extension of the current global economic slowdown and the economic consequences of additional military actions. Any similar geopolitical uncertainty in the future could harm our operating results and stock price.

We may not be successful in addressing problems encountered in connection with any acquisitions we may undertake, which could disrupt our operations or otherwise harm our business.

In the past, we have made acquisitions. We expect to continue to review opportunities to buy or make investments in other businesses, products or technologies that would enhance our technical capabilities, complement our current products or expand the breadth of our markets or that may otherwise offer growth opportunities. Our continued acquisitions of businesses or technologies will require significant commitment of resources. We may be required to pay for any acquisitions with cash, but we cannot be certain that additional capital will be available to us on favorable terms, if at all. In lieu of paying cash, we could issue stock as consideration for an acquisition that would dilute existing stockholders’ percentage ownership, incur substantial debt or assume contingent liabilities. We have limited experience in acquiring other businesses and technologies, including businesses with international operations. Potential and completed acquisitions and investments also involve numerous risks, including:

We may require substantial additional capital, which may not be available on acceptable terms or at all.

To the extent the proceeds of this offering and our existing sources of cash and cash flow from operations are not sufficient to fund our activities, we may need to raise additional funds. If we issue additional stock to raise capital, each stockholders’ percentage ownership in the Company would be reduced. Additional financing may not be available when needed on terms acceptable to us or at all. If we raise funds through debt financing, we will have to pay interest and may be subject to restrictive covenants, which could limit our ability to take advantage of future opportunities, respond to competitive pressures or unanticipated industry changes. If we cannot raise necessary additional capital on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities or respond to competitive pressures or unanticipated industry changes.

The price at which our common stock trades is likely to be highly volatile and may fluctuate substantially due to many factors, some of which are:

In addition, the stock market has experienced significant price and volume fluctuations that has affected the market prices for the common stock of technology companies. In the past, these market fluctuations were often unrelated or disproportionate to the operating performance of these companies. Any significant fluctuations in the future might result in a significant decline in the market price of our common stock.

We have implemented anti-takeover provisions that could discourage a third party from acquiring us and consequently cause our stock price to decline.

Our certificate of incorporation and bylaws contain provisions that may have the effect of delaying or preventing a change of control or changes in management that a stockholder might consider favorable. Our certificate and bylaws, among other things, provide for a classified board of directors, require that stockholder actions occur at duly called meetings of the stockholders, limit who may call special meetings of stockholders and require advance notice of stockholder proposals and director nominations. These provisions, along with the provisions of the Delaware General Corporation Law, such as Section 203, prohibiting certain business combinations with an interested stockholder, may delay or impede a merger, tender offer or proxy contest involving us. Any delay or prevention of a change of control transaction or changes in management could cause the market price of our common stock to decline.

We are exposed to the impact of changes in foreign currency exchange rates and changes in interest rates.

To date, most of our revenue has been denominated in U.S. dollars. We expect, however, an increasing amount of revenue from selected international markets to be denominated in the currency of the applicable market. As a result, our operating results may become subject to significant fluctuations based upon changes in the exchange rates of some currencies in relation to the U.S. dollar. Although we will continue to monitor our exposure to currency fluctuations and, when appropriate, may use economic hedging techniques to minimize the effect of these fluctuations, exchange rate fluctuations may harm our financial results. For the three and six months ended June 30, 2004, we did not have significant foreign currency denominated net assets or net liabilities positions, and had no foreign currency contracts outstanding.

We have limited exposure to financial market risks, including changes in interest rates. Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly because the majority of our investments are in short-term instruments. Due to the short-term nature of our investments, we believe that we are not exposed to any material market risk.

Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, and subject to the limitations described below, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to be disclosed in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

In connection with the completion of its audit of our financial statements for the year ended December 31, 2003, our independent auditors, KPMG LLP (“KPMG”) advised management and the Audit Committee of the Board of Directors that it had identified a deficiency in internal controls that rose to the level of a reportable condition under standards established by the American Institute of Certified Public Accountants. The reportable condition relates to our internal controls over revenue recognition due to (i) our lack of a formally documented revenue recognition policy, (ii) our failure, on certain occasions, to ensure that all contracts are appropriately executed, (iii) the absence of documentation supporting the Company’s revenue recognition for non-standard revenue agreements and (iv) our failure, on certain occasions, to document credit checks on new customers.

Our management, including the Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures will prevent all errors and all fraud. Because of inherent limitations on any systems of disclosure controls and procedures, no evaluation of controls can provide absolute assurance that all errors or fraud, if any, within a company can be detected.

During the quarter ended June 30, 2004, we implemented procedures and policies that we believe improves our ability to process and report accurate revenue numbers. Among these changes was the formalization of our revenue recognition policy, which not only documents and clarifies our policies surrounding revenue recognition but also documents the related processes in place to ensure these policies are adhered to.

Except for the above changes, there were no other significant changes in our internal controls over financial reporting identified in connection with the evaluation described in Item 4 above that occurred during the period covered by this quarterly report on Form 10-Q that has materially affected or is reasonably likely to materially affect our internal controls over financial reporting.

ITEM 2. CHANGE IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

On May 10, 2004, we announced a stock repurchase program pursuant to which we may purchase up to $10 million or 700,000 shares, of our outstanding common stock from time to time. The duration of the repurchase program is open-ended. Under the program, we may purchase shares of common stock through open market transactions at prices deemed appropriate by management. The timing and amount of repurchase transactions under this program depends on market conditions and corporate and regulatory considerations.

The following table summarizes the stock repurchases transactions that occurred during the quarter ended June 30, 2004.

We held our Annual Meeting of Stockholders on May 31, 2004. At the meeting, the following proposals received the votes listed below:

Proposal I. Election of Director, George Haber, for three-year term expiring 2007.

Proposal II. Approval of ratification of the appointment of KPMG LLP as independent auditors of the Company for the fiscal year ending December 31, 2004.

Exhibits filed with the Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 are as follows:

The Company filed the following Current Report on Forms 8-K during the quarter ended June 30, 2004:

On April 29, 2004, the Company furnished a Current Report on Form 8-K under Item 12 regarding the Company’s issuance of a press release announcing its earnings for the quarter ended March 31, 2004.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


Date:		August 16, 2004

InterVideo, Inc.
(Registrant)

By:		/s/ STEVE RO
		Steve Ro Chief Executive Officer

By:		/s/ RANDALL BAMBROUGH
		Randall Bambrough Chief Financial Officer


		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited):
	(a) Condensed Consolidated Balance Sheets at June 30, 2004 and December 31, 2003	3
	(b) Condensed Consolidated Statements of Income for the three months and six months ended June 30, 2004 and 2003	4
	(c) Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003	5
	(d) Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	39

Item 4.	Controls and Procedures	40

PART II. OTHER INFORMATION

Item 2.	Change in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities	41

Item 4.	Submission of Matters to a Vote of Security Holders	41

Item 6.	Exhibits and Reports on Form 8-K	42

Signatures		43


	June 30, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	33,652		$	46,875
Short-term investments		36,621			22,862
Accounts receivable, net of allowance for doubtful accounts of $149 and $254, respectively		7,012			5,515
Deferred tax assets		1,722			1,543
Prepaid expenses and other current assets		2,025			2,468

Total current assets		81,032			79,263

Property and equipment, net		2,321			2,241
Goodwill		1,018			1,018
Other purchased intangible assets		183			283
Deferred tax assets		4,685			4,685
Long term investments		1,662			—
Other assets		329			429

Total assets	$	91,230		$	87,919

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	912		$	1,039
Accrued liabilities		10,886			9,503
Income taxes payable		678			1,539
Deferred revenue		4,070			3,422

Total current liabilities		16,546			15,503

Stockholders’ equity:
Preferred Stock, $0.001 par value: 5,000 shares authorized; no shares issued and outstanding		—			—
Common stock, $0.001 par value: 150,000 shares authorized; 13,415 and 12,970 shares issued and outstanding, respectively		13			13
Additional paid-in capital		74,711			76,283
Notes receivable from stockholders		(925	)		(905	)
Deferred stock-based compensation		(241	)		(531	)
Accumulated other comprehensive loss		(286	)		(123	)
Retained earnings (accumulated deficit)		1,412			(2,321	)

Total stockholders’ equity		74,684			72,416

Total liabilities and stockholders’ equity	$	91,230		$	87,919


	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
Revenue	$	16,704	$	13,099	$	35,525	$	26,472
Cost of revenue		7,719		5,398		15,653		10,833

Gross profit		8,985		7,701		19,872		15,639

Operating expenses:
Research and development		2,608		1,907		4,897		3,621
Sales and marketing		2,713		2,120		5,471		4,395
General and administrative		1,975		901		3,680		1,854
Stock-based compensation⁽¹⁾		74		217		149		550

Total operating expenses		7,370		5,145		14,197		10,420

Income from operations		1,615		2,556		5,675		5,219

Other income, net		262		75		435		163

Income before income taxes		1,877		2,631		6,110		5,382
Provision for income taxes		747		1,057		2,377		2,200

Net income	$	1,130	$	1,574	$	3,733	$	3,182

Net income per share:
Basic	$	0.08	$	0.61	$	0.28	$	1.25

Diluted	$	0.07	$	0.13	$	0.24	$	0.26

Number of shares used in net income per share calculation:
Basic		13,410		2,561		13,314		2,551

Diluted		15,366		12,096		15,371		12,127


	Six months ended June 30,
	2004			2003
Cash flows from operating activities:
Net income	$	3,733		$	3,182
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		663			425
Deferred taxes		(182	)		(6	)
Stock-based compensation		149			550
Provision for doubtful accounts		(58	)		(53	)
Loss from disposal of property and equipment		25			8
Interest income on notes receivable from stockholders		(20	)		(20	)
Changes in operating assets and liabilities:
Accounts receivable		(1,452	)		(414	)
Prepaid expenses and other current assets		439			(1,580	)
Other assets		99			(29	)
Accounts payable		(122	)		263
Deferred revenue		655			107
Accrued liabilities and income taxes payable		528			(333	)

Net cash provided by operating activities		4,457			2,100

Cash flows from investing activities:
Purchases of property and equipment		(664	)		(170	)
Purchases of short-term investments		(54,428	)		(2,495	)
Proceeds from maturities of short-term investments		40,491			1,833
Purchase of long term investments		(1,662	)		—

Net cash used in investing activities		(16,263	)		(832	)

Cash flows from financing activities:
Proceeds from issuance of common stock under stock option and purchase plans		1,166			23
Repurchase of common stock for retirement		(2,596	)		—

Net cash provided by (used in) financing activities		(1,430	)		23

Effect of change in exchange rates on cash and cash equivalents		13			10

Net increase (decrease) in cash and cash equivalents		(13,223	)		1,301
Cash and cash equivalents, beginning of period		46,875			17,137

Cash and cash equivalents, end of period	$	33,652		$	18,438

Supplementary disclosures of non-cash investing and financing activities:
Deferred stock-based compensation, net of cancellation adjustments	$	(142	)	$	(102	)
Unrealized gain on available-for-sale investments		(178	)		17

Supplementary disclosure:
Income tax payments, net of refunds	$	1,899		$	1,285


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Numerator:
Net income	$	1,130		$	1,574		$	3,733		$	3,182

Denominator:
Basic:
Weighted average common shares outstanding		13,454			2,652			13,363			2,648
Less: weighted average shares subject to repurchase		(44	)		(91	)		(49	)		(97	)

Denominator for basic calculation		13,410			2,561			13,314			2,551

Net income per share - Basic	$	0.08		$	0.61		$	0.28		$	1.25

Diluted:
Weighted average common shares outstanding		13,454			2,652			13,363			2,648
Weighted average dilutive effect of convertible preferred stock		—			6,948			—			6,948
Weighted average dilutive effect of common stock options		1,912			2,496			2,008			2,531

Denominator for diluted calculation		15,366			12,096			15,371			12,127

Net income per share – Diluted	$	0.07		$	0.13		$	0.24		$	0.26


	Three months ended June 30,		Six months ended June 30,
	2004	2003	2004	2003
Common stock subject to repurchase	44	91	49	97
Antidilutive options to purchase common stock	858	65	796	38

Total	902	156	845	135


	Three months ended June 30,						Six months ended June 30,
(in thousands, except per share amounts)	2004			2003			2004			2003
Net income, as reported	$	1,130		$	1,574		$	3,733		$	3,182
Add: Stock-based employee compensation expenses included in reported net income, net of related tax effects		74			217			149			550
Deduct: Total stock-based employee compensation expenses determined under fair value method, net of related tax effects		(1,513	)		(544	)		(2,594	)		(1,219	)

Pro forma net income (loss)	$	(309	)	$	1,247		$	1,288		$	2,513

Net income (loss) per share
Basic – as reported	$	0.08		$	0.61		$	0.28		$	1.25

Basic – pro forma	$	(0.02	)	$	0.49		$	0.10		$	0.99

Diluted – as reported	$	0.07		$	0.13		$	0.24		$	0.26

Diluted – pro forma	$	(0.02	)	$	0.10		$	0.08		$	0.21


		Three and six months ended, June 30, 2004
Risk-free interest rate		2.97%
Expected life		1.25 years
Dividend yield		0%
Volatility		76.0%


	Three months ended June 30,					Six months ended June 30,
	2004		2003			2004		2003
Interest income	$	197	$	81		$	360	$	141
Other		65		(6	)		75		22

Other income, net	$	262	$	75		$	435	$	163


	Three months ended, June 30,					Six months ended, June 30,
	2004			2003		2004			2003
Net income	$	1,130		$	1,574	$	3,733		$	3,182
Other comprehensive income (loss):
Change in unrealized gain (loss) of available-for-sale investments		(209	)		5		(177	)		17
Change in cumulative translation adjustment		(16	)		13		14			13

Comprehensive income	$	905		$	1,592	$	3,570		$	3,212


	As of June 30, 2004
	Amortized cost		Gross unrealized losses			Estimated fair market value
Available-for-sale securities:
U.S. treasury and federal agency notes	$	24,624	$	(178	)	$	24,446
State and municipal notes/bonds		10,159		(43	)		10,116
Certificates of deposit		2,060		(1	)		2,059

Total short-term investments	$	36,843	$	(222	)	$	36,621


	As of December 31, 2003
	Amortized cost		Gross unrealized losses			Estimated fair market value
Available-for-sale securities:
U.S. treasury and federal agency notes	$	19,081	$	(38	)	$	19,043
Corporate bonds		276		—			276
Certificates of deposit		3,549		(6	)		3,543

Total short-term investments	$	22,906	$	(44	)	$	22,862


	June 30, 2004			December 31, 2003
Equipment	$	1,879		$	1,582
Furniture and fixtures		395			280
Purchased software		1,643			810
Leasehold improvements		506			492
Vehicles		126			115
Construction in process		—			703

		4,549			3,982
Less : Accumulated depreciation and amortization		(2,228	)		(1,741	)

Property and equipment, net	$	2,321		$	2,241


	June 30, 2004			December 31, 2003
Purchased development technology	$	1,000		$	1,000
Less: Accumulated amortization		(817	)		(717	)

Total other purchased intangible assets	$	183		$	283


July 1 to December 31, 2004	$	100
Year ending December 31, 2005		83

Total	$	183


	June 30, 2004		December 31, 2003
Payroll and related benefits	$	2,010	$	1,102
Royalties		7,103		7,052
Other		1,773		1,349

Total accrued liabilities	$	10,886	$	9,503


	June 30, 2004		December 31, 2003
Tangible long-lived assets:
United States	$	1,509	$	1,691
Asia:
Japan		283		147
China		383		481
Taiwan		475		351

Total tangible long-lived assets	$	2,650	$	2,670


	Three months ended June 30,		Percent Change		Six months ended June 30,		Percent Change
	2004	2003	Percent Change		2004	2003	Percent Change
Revenue	16,704	13,099	28	%	35,525	26,472	34	%


	Three months ended June 30,				Percent Change		Six months ended June 30,				Percent Change
	2004		2003		Percent Change		2004		2003		Percent Change
Stock-based compensation expenses	74		217		(66	)%	149		550		(73	)%
Percentage of total revenue	—	%	1	%			1	%	2	%


Exhibit footnote	Exhibit Number	Description
(a)	3.1	Certificate of Incorporation

(b)	3.2	Bylaws

(c)	4.1	Investors Rights Agreement, dated July 2, 1999, as amended, by and among Registrant and the parties who are signatories thereto

	31.1	Certification of the Chief Executive Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002

	31.2	Certification of the Chief Financial Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002

	32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

	32.2	Certification of the Chief Financial Officer pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002