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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

Form 10-Q

(Mark one)

For the quarterly period ended December 31, 2004

or

For the transition period from                      to                     

Commission File Number: 72870

SONIC SOLUTIONS

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (415) 893-8000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x     No ¨

Indicate by check mark whether the registrant is an accellerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x     No ¨

The number of outstanding shares of the registrant’s Common Stock on February 7, 2005, was 24,277,508.

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SONIC SOLUTIONS

FORM 10-Q

For the quarterly period ended December 31, 2004

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PART I – FINANCIAL INFORMATION

Sonic Solutions

Condensed Consolidated Balance Sheets

(in thousands, except per share amounts)

See accompanying notes to condensed consolidated financial statements.

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Sonic Solutions

Condensed Consolidated Statements of Operations

(in thousands, except per share amounts — unaudited)

See accompanying notes to condensed consolidated financial statements.

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Sonic Solutions

Condensed Consolidated Statements of Cash Flows

(in thousands — unaudited)

See accompanying notes to condensed consolidated financial statements.

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Sonic Solutions

Notes to Condensed Consolidated Financial Statements

(unaudited)

The accompanying unaudited consolidated financial statements of Sonic Solutions, referred to as “we,” “Sonic,” “our” or “the Company,” 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 complete financial statements. However, in the opinion of management, the consolidated financial statements include all adjustments, consisting of only normal, recurring adjustments, necessary for their fair presentation. The interim results are not necessarily indicative of results expected for a full year. These unaudited condensed consolidated financial statements should be read in conjunction with the financial statements and related notes included in the Company’s Form 10-K for the year ended March 31, 2004, filed with the Securities and Exchange Commission.

Principles of Consolidation and Basis of Presentation

The accompanying consolidated financial statements include the accounts of our subsidiaries. All intercompany balances and transactions have been eliminated on consolidation.

During the quarter ended June 30, 2003 we established a wholly owned subsidiary in Japan, called “Sonic Japan KK.” We transferred a total of 6 employees into this new subsidiary. This subsidiary was established because of the increased level of business we have encountered in Japan, to potentially lower our overall tax rate, and to increase our level of direct contact with important Japanese customers, particularly those OEM customers utilizing our consumer software products.

During the quarter ended September 30, 2003, we established a wholly owned subsidiary in China, called “Sonic Solutions Shanghai China,” and hired a number of engineers to work for this new subsidiary. We established this subsidiary in response to the growing demand for our CD/DVD creation technology worldwide. This new subsidiary allows us to tap into the large pool of engineering talent in China, speeding the development and deployment of our products and technologies to our customers. The subsidiary also brings additional reach to our operations which include development and sales offices in North America, Europe, Japan and Taiwan.

During the quarter ended March 31, 2004, we established a wholly owned U.S. subsidiary in connection with the acquisition of InterActual Technologies (“InterActual”). This subsidiary includes all the acquired assets and liabilities of InterActual, including their portfolio of patents and patent applications, the InterActual Player, and all engineering and service operations personnel.

In connection with the acquisition of the consumer software division (“CSD”) of Roxio, Inc. (“Roxio”), we acquired wholly owned subsidiaries in Canada, Japan and the United Kingdom which provide engineering, technical support and sales and marketing services. Additionally, we acquired three dormant subsidiaries in France, Israel and the Cayman Islands.

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Use of Estimates and Certain Concentrations

We prepare our financial statements in conformity with U.S. generally accepted accounting principles. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Our management is also required to make certain judgments that affect the reported amounts of revenues and expense during the reporting period. We periodically evaluate our estimates including those relating to revenue recognition, the allowance for doubtful accounts, capitalized software, and other contingencies. We base our estimates on historical experience and various other assumptions that we believe to be reasonable based on the specific circumstances, the results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates.

We are dependent on sole-source suppliers for certain key components used in our products. We purchase these sole-source components pursuant to purchase orders placed from time to time. We do not carry significant inventories of these components, and have no guaranteed supply agreements. Any extended future interruption or limitation in the supply of any of the components obtained from a single source could have a material adverse effect on our results of operations.

Revenue Recognition

We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 “Deferral of the Effective Date of a Provision of SOP 97-2,” and SOP 98-9, “Software Revenue Recognition, with Respect to Certain Arrangements” and in certain instances in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements such as software products, hardware, upgrades, enhancements, maintenance and support, installation and training to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on vendor-specific objective evidence.

We derive our software revenue primarily from licenses of our software products, including any related hardware components, development agreements and maintenance and support. Revenue recognized from multiple-element software arrangements is allocated to each element of the arrangement based on the fair values of elements, for example, the license to use software products versus maintenance and support for the software product. The determination of fair value is based on objective evidence specific to us. Objective evidence of fair values of all elements of an arrangement is based upon our standard pricing and discounting practices for those products and services when sold separately. Objective evidence of support services is measured by annual renewal rates. SOP 98-9 requires recognition of revenue using the “residual method” in a multiple element arrangement when fair value does not exist for one or more of the delivered elements in the arrangement. Under the “residual method,” the total fair value of the undelivered element is deferred and subsequently recognized in accordance with SOP 97-2. The difference between the total software arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements. We record revenue on a net basis for those sales in which we have in substance acted as an agent or broker in the transaction.

Revenue from license fees is recognized when persuasive evidence of an arrangement exists (such as receipt of a signed agreement, purchase order or a royalty report), delivery of the product (including hardware) has occurred (generally F.O.B. shipping point), no significant obligations with regard to implementation remain, the fee is fixed and determinable, and collectibility is probable. In addition, royalty revenue from certain distributors that do not meet

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our credit standards are recognized upon sell-through to the end-customer. We consider all arrangements with payment terms longer than one year not to be fixed and determinable. If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer.

Revenue from development agreements, whereby the development is essential to the functionality of the licensed software, is recognized over the performance period based on proportional performance. Under this method, management is required to estimate the number of hours needed to complete a particular project, and revenues and profits are recognized as the contract progresses to completion.

Revenue from software product sales to distributors and retailers are recognized upon product shipment to the distributors or retailers or receipt of the products by the distributor or retailer, depending on the shipping terms, provided that all fees are fixed or determinable, evidence of an arrangement exists and collectibility is probable. Our arrangements provide distributors with certain product rotation rights. Additionally, we permit our distributors to return products in certain circumstances, generally during periods of product transition. End users additionally have the right to return their product within 30 days of the purchase. We establish allowances for expected product returns in accordance with SFAS No. 48, “Revenue Recognition When Right of Return Exists,” and Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition in Financial Statements”. These allowances are recorded as a direct reduction of revenues and as a contra to net Accounts Receivable. Management applies significant judgment and relies on historical experience in establishing these allowances. If future return patterns differ from past return patterns, due to reduced demand for our product or other factors beyond our control, we may be required to increase these allowances in the future and may be required to reduce future revenues.

Deferred revenue includes amounts billed to customers for which revenues have not been recognized which results from the following: (1) deferred maintenance and support; (2) amounts billed to certain distributors for our products not yet sold through to the end-user customers; (3) amounts billed to technology and InterActual customers during either the current fiscal year or in prior fiscal years for license and development agreements in advance of recognizing the related revenue; and (4) amounts billed to certain original equipment manufacturers (OEMs) for products which contain one or more undelivered elements.

Unbilled receivables represents estimated amounts to be received by us from Roxio customers after December 17, 2004 related to revenue earned by Roxio prior to December 17, 2004.

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The following table sets forth the computations of shares and net income per share, applicable to common shareholders used in the calculation of basic and diluted net income per share for the third quarter and nine months ended December 31, 2003 and 2004 (in thousands, except per share data), respectively:

The following is a reconciliation of the number of shares used in the basic and diluted net income per share computations for the third quarter and nine months ended December 31, 2003 and 2004 (in thousands, except per share data), respectively:

Potential dilutive common shares consist of shares issuable upon exercise of stock options. The impact of our stock options on the shares used for the diluted earnings per share computation is calculated based on the average share price of our common stock for each year using the treasury stock method.

We exclude all potentially dilutive securities from our diluted net income per share computation when their effect would be anti-dilutive. The computation of diluted net income per share excludes stock options to purchase 1,605,524 and 2,805,396 shares of common stock for the third quarter and nine months ended December 31, 2003 and 2004, respectively. The shares were excluded due to the exercise price exceeding the average fair value of the common stock, and their inclusion would have been anti-dilutive. The computation of our diluted net income per share for the quarter ended December 31, 2004 excludes 3,660,000 shares of common shares resulting from stock options, as their inclusion would have been anti-dilutive.

We account for share-based employee compensation using the intrinsic value method in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and comply with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended.

Had compensation cost for stock options issued pursuant to our stock option plan been determined in accordance with the fair value approach enumerated in SFAS No. 123, our net

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income (loss) and net income (loss) per share for the third quarter and nine months ended December 31, 2003 and 2004 would have been adjusted as indicated below (in thousands, except per share data):

The weighted-average fair value of options granted in the three and nine months ended December 31, 2004 was $13.50 and $11.32, respectively, and in the three and nine months ended December 31, 2003 was $11.78 and $7.02, respectively. The fair value of options granted was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in the three and nine months ended December 31, 2004 and 2003: risk-free interest rate of 3.5% and 3.2% for the three and nine months ended December 31, 2004, respectively, and of 3.0% and 2.3% for the three and nine months ended December 31, 2003, respectively; expected life of 4.0 and 3.6 years for the three and nine months ended December 31, 2004, respectively, and of 4.0 and 3.4 for the three and nine months ended December 31, 2003, respectively; expected volatility of 88% and 89% for the three and nine months ended December 31, 2004, respectively and of 114% and 106% for the three and nine months ended December 31, 2003, respectively; and no dividends.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our stock options have characteristics significantly different from those of traded options, and because changes with respect to the subjective assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our stock options.

The effect of applying SFAS No. 123 for disclosing compensation costs may not be representative of the effects on reported net income for future periods because pro forma net

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income reflects compensation costs only for stock options granted in fiscal 1996 through 2003 and does not consider compensation costs for stock options granted prior to April 1, 1995.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment”. SFAS 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements using a fair-value-based method. The statement replaces SFAS 123, supersedes APB 25, and amends SFAS No. 95, “Statement of Cash Flows”. We are required to adopt SFAS 123R no later than our second quarter of fiscal 2006 which ends September 30, 2005. While the fair value method under SFAS 123R is very similar to the fair value method under SFAS 123 with regards to measurement and recognition of stock-based compensation, management is currently evaluating the impact of several of the key differences between the two standards on our financial statements. For example, SFAS 123 permits us to recognize forfeitures as they occur while SFAS 123R will require us to estimate future forfeitures and adjust our estimate on a quarterly basis. While we continue to evaluate the impact of SFAS 123R on our financial statements, we believe that the expensing of stock-based compensation will have an impact on our Condensed Consolidated Income Statement similar to our pro forma disclosure under SFAS 123, as amended.

The components of inventory consist of (in thousands):

The components of all intangible assets were as follows: (in thousands):

Purchased and internally developed software:

During the third quarters ended December 31, 2003 and 2004 we amortized approximately $86,000 and $110,000, respectively. During the nine months ended December 31, 2003 and 2004, we amortized approximately $272,000 and $384,000, respectively.

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Acquired Intangibles:

The acquired intangibles are being amortized on a straight-line basis over their estimated useful lives. Amortization of acquired intangibles was $326,000, $198,000, $209,000 and $158,000 for the quarters ended December 31, 2004, September 30, 2004, June 30, 2004 and March 31, 2004, respectively. The future annual amortization expense is expected to be as follows (in thousands):

We evaluate the remaining useful life of intangible assets not subject to amortization on each reporting period to determine whether events and circumstances continue to support an indefinite useful life. If an intangible asset that is not being amortized is subsequently determined to have a finite useful life, the asset is tested for impairment. That intangible asset shall then be amortized prospectively over its estimated remaining useful life and accounted for in the same manner as other intangible assets that are subject to amortization.

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The following table presents a rollforward of the goodwill and acquired intangibles as of December 31, 2004 (in thousands):

On December 17, 2004 Sonic Solutions and Roxio entered into an Amended and Restated Asset Purchase Agreement (the “Amended Purchase Agreement”) related to the purchase by Sonic Solutions of Roxio’s CSD and announced that it had completed its previously announced purchase of the CSD. The Amended Purchase Agreement amended and restated the Asset Purchase Agreement which Sonic Solutions and Roxio entered into on August 9, 2004 (the “Original Purchase Agreement” and together with the Amended Purchase Agreement, the “Purchase Agreement”). Sonic acquired Roxio CSD to enhance its retail distribution.

Under the terms of the transaction, Sonic acquired substantially all of the assets of the CSD, including all products, intellectual property and trademarks, including the “Roxio” name. Under the terms of the Purchase Agreement, Sonic Solutions paid Roxio $70.0 million and issued Roxio 653,837 shares of Sonic common stock (together, the “Purchase Price”), plus an aggregate of approximately $2.3 million representing certain additional amounts payable under the Purchase Agreement pursuant to working capital and channel inventory adjustment calculations. The common stock is valued using the closing price of Sonic’s stock for the two days before through two days following August 9, 2004. In addition, the Amended Purchase Agreement anticipates certain potential additional adjustments of the cash portion of the Purchase Price based on the final working capital calculations.

The transaction was accounted for as a purchase. Under purchase accounting, the purchase price will be allocated to assets purchased and liabilities assumed based on their relative fair values with the excess recorded as goodwill. Based on a preliminary evaluation and review of the assets, the amounts and components of the purchase price along with the allocation of the purchase price are as follows:

The final purchase price and accounting for the acquisition is dependent on receipt and acceptance by us of the closing date audited financial statements and on the receipt of the outstanding OEM royalty reports.

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The estimated transaction costs above include approximately $1,000,000 of transaction related liabilities of Sonic including approximately $700,000 for severance payments to former CSD employees and approximately $300,000 for exit costs associated with CSD facilities. These restructuring plans will be executed within a few months of the date of close of the transaction. As part of the acquisition of Roxio, we assumed certain restructuring liabilities that consist primarily of lease obligations for certain facilities previously exited by Roxio.

The value of identifiable intangible assets was determined in accordance with Statement of Financial Accounting Standard No. 141 “Business Combinations”. Core developed technology represents technology products that had been introduced into the market, were generating revenue and or had reached technological feasibility as of the close of the transaction. The value is calculated based on an estimate of the implicit income derived from this technology. Core developed technology is estimated to have a useful life of four to five years, amortized on a straight line basis. The value of customer contracts represents the implicit income derived as a result of the distribution channels and customers of the CSD. Based on historical attrition rates, the useful life of the customer contracts is estimated to be 10 years, amortized on a straight line basis. The value of tradenames is calculated based on the overall revenue stream of products and an estimated royalty rate. The royalty rate was determined in part by reviewing industry data regarding royalties paid for the use of a third party tradename. Based on the plan to continue to use the existing tradenames, the useful life is indefinite and accordingly the value will not be amortized.

Acquired in-process technology includes the value of products in the development stage that are not considered to have reached technological feasibility or have alternative future use. Accordingly, the acquired in-process technology was expensed in the Condensed Consolidated Statement of Operations upon consummation of the acquisition.

We incurred additional expenses of approximatley $1,087,000 to transition the Roxio business into our existing operations. These expenses include incremental costs consisting primarily of employee severance and lease exit costs totaling approximately $491,000 and a portion of internal payroll costs for those employees who worked on the acquisition totaling approximately $596,000. These expenses are included in our Condensed Consolidated Statement of Operations.

Results for the CSD have been included in our consolidated results beginning on December 18, 2004. The following pro forma results of operations for the three and nine months ended December 31, 2004 and 2003 are as if the acquisition occurred on April 1, 2004 and 2003. The pro forma information has been presented for illustrative purposes only and is not necessarily indicative of the combined financial position or results of operations for future periods or the results of operations or financial position that actually would have been realized had we been a combined company during the specified period. The pro forma information excludes non-recurring items which consist of acquired in-process technology expense of $3,100,000 and business integration expense of $491,000.

(in thousands, except per share amounts)

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On June 23, 2004, we announced an underwritten public offering of 1,300,000 shares of our common stock to institutional investors at a price of $19.48 per share for gross proceeds of $25,324,000. The transaction was completed and the stock was issued to investors on June 28, 2004. We received net proceeds of approximately $23,901,000 after deducting underwriting discounts and expenses associated with the offering.

In conjunction with our acquisition of the CSD and pursuant to the terms of the Purchase Agreement, Sonic Solutions issued Roxio 653,837 shares of Sonic Solutions common stock (the “Shares”) as part of the Purchase Price for the Roxio consumer software division. Under the terms of the Amended Purchase Agreement, Sonic Solutions has agreed to file a registration statement with respect to the sale of the Shares by Roxio.

We from time to time are subject to routine claims and litigation incidental to our business. InterActual was a defendant in a lawsuit entitled Trust Licensing, LLC and Leigh Rothschild v. InterActual Technologies, Inc. in the United States District Court for the Southern District of Florida (Civil Action No. 03-20672) in which it was charged with patent infringement and other wrongdoing. As a result of a court-sponsored mediation, InterActual and the plaintiffs executed a

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settlement agreement on January 28, 2004, and InterActual agreed to pay $500,000 to the plaintiffs. $225,000 of this amount was paid in January 2004 and the remaining $275,000 was evidenced by a note. However, after learning of our acquisition of InterActual, the plaintiffs filed a motion to have the settlement set aside. On May 6, 2004 we executed a final settlement agreement, in which we agreed to cancel the note payable of $275,000 and to pay an additional $475,000, which was paid on May 21, 2004. The additional settlement amount is expected to be settled through an adjustment to the escrow holdback set aside for the former InterActual shareholders. We believe that the results of routine claims and litigation incidental to our business will not have a material adverse effect on our financial condition and results of operations.

As part of the Roxio CSD acquisition, we acquired all of the capital stock of MGI Software Corp. (“MGI Software”) Prior to the Roxio CSD acquisition, Roxio and MGI were notified by a number of companies that certain of their respective software products, which were acquired by us in the Roxio CSD acquisition, may infringe patents owned by those companies. In addition, Roxio and MGI Software were notified by a number of original equipment manufacturer (“OEM”) customers, who bundle the Roxio and MGI software products with their own computer products, that such OEMs were approached by certain of these companies claiming possible patent infringement by Roxio and MGI Software. We have accrued $2.4 million on our balance sheet related to the settlement of the MGI Software-related patent infringement claims, of which $2.4 million was recorded as part of the purchase price allocation of MGI Software. The amount, if any, necessary to settle patent claims related to Roxio’s software products cannot be determined at this time. There are no assurances that the amount we have accrued to settle the MGI Software-related patent infringement claims is sufficient.

On April 23, 2002, Electronics for Imaging and Massachusetts Institute of Technology filed action against 214 companies in the Eastern District of Texas, Case No. 501 CV 344, alleging patent infringement. Roxio and MGI Software are named as defendants in that action, along with some of their customers. As part of the Roxio CSD acquisition, we inherited any potential liability related to this suit. The plaintiffs are seeking unspecified damages. The patent at issue in the case has expired, and we intend to continue to defend the action. Because the case is at an early state, the outcome cannot be predicted with any certainty.

On December 12, 2003, Optima Technology Corporation filed a lawsuit against us in U.S. District Court for the Central District of California, Case No. 03-1776-JVS-ANx, alleging infringement of certain of their patents by Roxio, Inc.’s Easy CD Creator line of products. Optima is seeking unspecified damages and injunctive relief. As part of the Roxio CSD acquisition, Inc., we inherited any potential liability related to this suit, and have been joined as a co-defendant in the case. We believe the claims are without merit and intend to defend ourselves vigorously. On February 20, 2004, Roxio, Inc. filed a countersuit against Optima Technology Corporation alleging infringement of certain of its patents by their CD-R Access Pro product. We also inherited this countersuit. We are seeking unspecified damages and injunctive relief. A status conference was held in November 2004, and a trial date is set for November 1, 2005.

On December 15, 2004 we entered into a Loan and Security Agreement (the “Loan Agreement”) with Union Bank of California, N.A. (“UBOC”) that provides for a three-year revolving credit facility (the “Credit Facility”). Total availability under the Credit Facility is $40,000,000 through the first anniversary of the Loan Agreement, $35,000,000 through the second anniversary of the Loan Agreement and $30,000,000 at all times thereafter. The Credit Facility also provides for letters of credit up to the availability of the Credit Facility, less any outstanding borrowings under the Credit Facility. The Credit Facility matures on September 30, 2007 with interest only payments due monthly through the maturity date. The Credit Facility was obtained for general corporate purposes, including for working capital and to finance a portion of our purchase of the consumer software product division of Roxio. On December 14, 2004 we drew down $30,000,000 under the Credit Facility.

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The interest rate charged on borrowings under the Credit Facility can vary depending on the types of loans Sonic selects. Our options for the rate include (a) the Base Rate or (b) a LIBOR Rate plus an applicable margin (the “LIBOR Option”). The Base Rate is defined in the Loan Agreement as the higher of the Federal Funds rate as in effect from time to time plus 0.5% or the rate of interest most recently announced from time to time by UBOC as its United States Dollar “reference rate.” The applicable margin for LIBOR loans is 1.50%.

The Credit Facility is guaranteed by and secured by substantially all of our assets, including assets of our domestic subsidiaries who are guarantors of the Credit Facility. Under the terms of the Loan Agreement, we are subject to certain limitations, including limitations on our ability to: incur additional debt; sell assets; make distributions; make investments; make acquisitions and to grant liens. Sonic is also subject to financial covenants, which include maintenance of specified financial ratios and net profit amounts. We have the ability, within 60 days of the closing of the Roxio CSD acquisition, to propose revised covenants to UBOC to reflect the closing of the transaction. If Sonic and UBOC are unable to agree on revised covenants, and Sonic is unable or unwilling to abide by the existing covenants, Sonic is required repay all amounts outstanding under the Loan Agreement, and the Loan Agreement will terminate, on the earlier of (1) 135 days after the date of the closing of the Roxio CSD acquisition or (2) the occurrence of specified Events of Default (as defined in the Loan Agreement). The Credit Facility is subject to customary events of default, the occurrence of which could lead to an acceleration of the Company’s obligations thereunder.

We lease certain facilities and equipment under noncancelable operating leases. Rent expense under operating leases was approximately $524,000 and $734,000 for the third quarters ended December 31, 2003 and 2004, respectively, and was approximately $1,529,000 and $1,855,000 for the nine months ended December 31, 2003 and 2004, respectively.

In connection with the Roxio CSD acquisition, we assumed almost all of the liabilities and obligations of the CSD software division, including:

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Future payments under various operating and capital leases that have initial remaining noncancelable lease terms in excess of one year are as follows (in thousands):

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires us to report financial and descriptive information about our reportable operating segments, including segment profit or loss, certain specific revenue and expense items and segment assets, as well as information about the revenues derived from our products and services, the countries in which we earn revenue and hold assets, and major customers. The method for determining what information to report is based on the way that management organized the operating segments within our company for making operating decisions and assessing financial performance.

Our President and Chief Executive Officer (the “CEO”) is considered our chief operating decision maker. The CEO reviews financial information presented on a consolidated basis accompanied by desegregated information about revenue by product line and revenue by geographic region for purposes of making operating decisions and assessing financial performance. Financial information reviewed by management includes not only revenue by product line, but also gross margin analysis and operating income for the related operating segments. The consumer segment includes software-only DVD-Video creation tools and DVD-Video playback software products intended for use by lower end professionals, enthusiasts or “prosumers,” and consumers, and software-only CD-Audio, CD-ROM and DVD-ROM making tools, as well as data backup software. Included in this segment is also the software we recently acquired in connection with the Roxio CSD acquisition. Our consumer products also include software that we license to other companies for inclusion in their products. Our professional audio and video segment includes advanced DVD-Video creation tools which are intended for use by high-end professional customers. The following table shows the revenue by product line, operating results by segment, revenue by geographic location and significant customer information:

Revenues by Segment (in thousands):

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Revenue and Operating Income by Segment (in thousands):

Net Revenue and Operating Income by Segment (in thousands):

Net Revenue by Geographic Location (in thousands):

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We sell our products to customers categorized geographically by each customer’s country of domicile.

Significant Customer Information (in thousands):

Revenue recognized from Customers A and B is pursuant to licensing agreements.

Revenue recognized from Customer C is pursuant to licensing and development agreements.

The components of comprehensive income, net of tax, were as follows (in thousands):

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In March 2004, the FASB issued EITF Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. We will evaluate the impact of EITF 03-1 once final guidance is issued.

In October 2004, the EITF reached a consensus on EITF Issue No. 04-1, “Accounting for Preexisting Relationships between the Parties to a Business Combination.” The consensus requires that a business combination between two parties that have a preexisting relationship should be evaluated to determine if a settlement of a preexisting relationship exists, and thus requiring accounting separate from the business combination. The consensuses reached in EITF 04-1 should be applied prospectively to business combinations and goodwill impairment tests completed in reporting periods beginning after October 13, 2004. We do not anticipate the adoption of EITF 04-1 will have a material effect on the Company’s financial position or results of operations.

In November 2004, the FASB issued SFAS No. 151 (“SFAS 151”), “Inventory Costs - an amendment of ARB No. 43, Chapter 4”. SFAS 151 amends the guidance in Accounting Research Bulletin (“ARB”) 43, “Restatement and Pension of Accounting Research Bulletins”, Chapter 4, “Inventory Pricing”, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) and requires that those items be recognized as current-period charges. SFAS 151 also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Management believes the adoption of SFAS 151 will not have a material impact on our financial statements.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment”. SFAS 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements using a fair-value-based method. The statement replaces SFAS 123, supersedes APB 25, and amends SFAS No. 95, “Statement of Cash Flows”. We are required to adopt SFAS 123R no later than our second quarter of fiscal 2006 which ends September 30, 2005. While the fair value method under SFAS 123R is very similar to the fair value method under SFAS 123 with regards to measurement and recognition of stock-based compensation, management is currently evaluating the impact of several of the key differences between the two standards on our financial statements. For example, SFAS 123 permits us to recognize forfeitures as they occur while SFAS 123R will require us to estimate future forfeitures and adjust our estimate on a quarterly basis. While we continue to evaluate the impact of SFAS 123R on our financial statements, we believe that the expensing of stock-based compensation will have an impact on our Condensed Consolidated Income Statement similar to our pro forma disclosure under SFAS 123, as amended.

On February 3, 2004, we signed an Amendment No. 3 to our office lease for our Novato Headquarter’s office. The terms of the Amendment extend the term, which was originally set to expire on May 31, 2006, to January 31, 2010.

In connection with the assignment of a lease of approximately 70,000 square feet in a facility located in Santa Clara, California (the “Santa Clara Lease”) from Roxio to Sonic, we have provided a letter of credit to Entrust, the sublandlord under the Santa Clara lease, in the amount of $700,000 issued by Union Bank of California under the terms of our existing revolving credit facility.

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CERTAIN FACTORS THAT MAKE FUTURE RESULTS DIFFICULT TO PREDICT; CERTAIN ITEMS TO REMEMBER WHEN READING OUR FINANCIAL STATEMENTS

Our quarterly and annual operating results vary significantly depending on the timing of new product introductions and enhancements by ourselves and by our competitors. Our results also depend on the volume and timing of our professional customer orders and on shipments of our original equipment manufacturer (OEM) partners which are difficult to forecast. Because our professional customers generally order on an as-needed basis and we normally ship products within one week after receipt of an order, and because our OEM partners report shipments during or after the end of the period, we do not have an order backlog which can assist us in forecasting results. For all these reasons, our results of operations for any quarter or any year are a poor indicator of the results to be expected in any future quarter or year.

A large portion of our quarterly professional product revenue is usually generated in the last few weeks of the quarter. We receive a disproportionate share of OEM royalty reports around the end of the quarter. Also, our OEM partners do not always transmit their royalty reports to us in time to be included in our quarterly revenues. Since our ongoing operating expenses are relatively fixed, and we plan our expenditures based primarily on sales forecasts, if professional revenue generated in the last few weeks of a quarter or year or reported OEM partner shipments do not meet our forecast, our operating results may be very negatively affected.

OVERVIEW

We develop and market computer based tools:

Most of the products we sell consist entirely of computer software, though some of the tools we sell include “plug-in” computer hardware. We also license the software technology underlying our tools to various other companies to incorporate in products they develop.

Our business is divided into two reporting segments, our consumer segment and our professional audio and video segment. At the same time, we divide our products into three categories: Professional Audio and Video products, Desktop products (which includes the recently acquired Roxio CSD products) and Technology products.

On December 17, 2004 we acquired the assets of the consumer software division of Roxio for $70.0 million in cash and 653,837 shares of Sonic common stock, plus an aggregate of approximately $2.3 million representing certain additional amounts payable under the Purchase Agreement pursuant to working capital and channel inventory adjustment calculations. In the acquisition, we acquired Roxio’s CD and DVD recording, authoring, photo and video application products and substantially all of the Software Division’s patents and trademarks, and assumed substantially all the liabilities of the Software Division. Two hundred and twelve former employees of Roxio CSD joined our company. With this acquisition we will now have an additional source of revenue. The majority of the revenues from the Roxio products are derived from sales of software to end users through retailers. Retailers buy the products from national and international distributors,

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including Navarre Corporation and Ingram Micro. The retailers include traditional PC and software retailers as well as office superstores, warehouse clubs and cataloguers. We also sell basic versions of the Roxio software with fewer features than the retail versions directly to manufacturers of PCs, optical recorders, printers, scanners, digital cameras and digital vide camcorders. The Roxio products are included in our consumer segment.

Our revenue growth for the third quarter of fiscal 2005, which amounted to an increase of 33% from the same period in the prior year, was driven mainly by an increase in sales of our consumer products primarily through new and existing OEM licensing agreements and from sales of the consumer products acquired with the Roxio CSD software acquisition which was completed in December 2004. International sales decreased to 15% of our net revenue for the third quarter of fiscal year 2005 from 40% of our net revenue for the third quarter of fiscal year 2004. The percentage of international sales as a component of our net revenues decreased primarily due to the increase in revenue on licensing agreements from customers domiciled in the United States. Approximately 60% of our net revenue for the third quarter of fiscal year 2005 resulted from three customers, with one customer accounting for 47% of our net revenue for the period. The loss of any of these customers would have a material adverse effect on our financial results.

As a result of our recent acquisitions, as well as the general expansion of our business, we are a much larger organization with more employees and greater geographical presence. Our headcount increased from 253 at December 31, 2003 to 575 at December 31, 2004. Our international presence also increased with offices now in Canada and various Asian and European countries. Also in connection with the Roxio CSD acquisition, we have a more diversified business model with increased revenue generated domestically, more retail sales and more strategic relationships with national and international distributors. As we transition to the next phase of our company’s expansion and development, we will be faced with the challenges associated with the continued integration of recent acquisitions, the complementation of additional standards, controls, procedures and policies to reflect our larger organization and the management of our more diversified and complex business model.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

We prepare our financial statements in conformity with U.S. generally accepted accounting principles. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Our management is also required to make certain judgments that affect the reported amounts of revenues and expense during the reporting period. We periodically evaluate our estimates including those relating to revenue recognition, the allowance for doubtful accounts and returns, capitalized software, and other contingencies. We base our estimates on historical experience and various other assumptions that we believe to be reasonable based on the specific circumstances, the results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates.

We believe the following critical accounting policies impact the most significant judgments and estimates used in the preparation of our financial statements:

Revenue recognition rules for software companies are very complex. We follow very specific and detailed guidance in measuring revenue. Certain judgments, however, affect the application of our revenue recognition policy.

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We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 “Deferral of the Effective Date of a Provision of SOP 97-2,” and SOP 98-9, “Software Revenue Recognition,” with respect to certain arrangements and in certain instances in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” SOP 97-2 requires revenue earned on software arrangements involving multiple elements such as software products, hardware, upgrades, enhancements, maintenance and support, installation and training to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on vendor-specific objective evidence.

We derive our software revenue primarily from licenses of our software products (including any related hardware components), development agreements and maintenance and support. Revenue recognized from multiple-element software arrangements is allocated to each element of the arrangement based on the fair values of elements, for example, the license to use the software products versus maintenance and support for the software product. The determination of fair value is based on objective evidence specific to us. Objective evidence of fair values of all elements of an arrangement is based upon our standard pricing and discounting practices for those products and services when sold separately. Objective evidence of support services is generally measured by annual renewal rates. SOP 98-9 requires recognition of revenue using the “residual method” in a multiple element arrangement when fair value does not exist for one or more of the delivered elements in the arrangement. Under the “residual method,” the total fair value of the undelivered elements are deferred and subsequently recognized in accordance with SOP 97-2. The difference between the total software arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements. We record revenue on a net basis for those sales in which we have in substance acted as an agent or broker in the transaction.

Revenue from license fees is recognized when persuasive evidence of an arrangement exists, delivery of the product (including hardware) has occurred, no significant obligations with regard to implementation remain, the fee is fixed and determinable, and collectability is probable.

In addition, royalty revenue from certain distributors that do not meet our credit standards is recognized upon sell-through to the end-customer. We consider all arrangements with payment terms longer than one year not to be fixed and determinable. If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer.

Revenue from development agreements, whereby the development is essential to the functionality of the licensed software, is recognized over the service period based on proportional performance. Under this method, management is required to estimate the number of hours needed to complete a particular project, and revenues and profits are recognized as the contract progresses to completion.

Revenue from software product sales to distributors are recognized upon product shipment to the distributors or receipt of the products by the distributor, depending on the shipping terms, provided that all fees are fixed or determinable, evidence of an arrangement exists and collectibility is probable. Our distributor arrangements provide distributors with certain product rotation rights. Additionally, we permit our distributors to return products in certain circumstances, generally during periods of product transition. End users additionally have the right to return their product within 30 days of the purchase. We establish allowances for expected product returns in accordance with SFAS No. 48, “Revenue Recognition When Right of Return Exists,” and Staff Accounting Bulletin 104 “Revenue Recognition in Financial Statements”. These allowances are recorded as a direct reduction of revenues and as a contra to net accounts receivable. Management applies significant judgment and relies on historical experience in establishing these allowances. If future return patterns differ from past return patterns, due to reduced demand for our product or other factors beyond our control, we may be required to increase these allowances in the future and may be required to reduce future revenues.

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Deferred revenue includes amounts billed to customers for which revenues have not been recognized which results from the following: (1) deferred license, maintenance and support; (2) amounts billed to certain distributors for our products not yet sold to the end-user customers; (3) amounts billed in excess of services performed to technology customers for license and development agreements; and (4) amounts billed to certain OEMs for products which contain one or more undelivered elements.

In connection with the Roxio CSD acquisition we recorded approximately $397,000 as unbilled receivables which represent our estimate of the OEM royalty reports we expect to receive after December 17, 2004 for shipments prior to December 17, 2004.

We maintain an allowance for returns and doubtful accounts to reflect the expected non-collection of accounts receivable based on past collection history and specific risks identified in our portfolio of receivables. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make payments, or if payments from customers are significantly delayed, additional allowances may be required.

Our distributor and retail arrangements provide for certain product rotation rights and permit return of products in certain circumstances. End users additionally have the right to return their product within 30 days of purchase. We maintain reserves for these estimated rights and returns.

We capitalize a portion of our software development costs in accordance with Statement of Financial Accounting Standard (SFAS) No. 86 “Accounting for the Costs of Computer Software to be Sold, Leased, or otherwise Marketed.” Such capitalized costs are amortized to cost of revenue over the estimated economic life of the product, which is generally three years. Periodically, we compare a product’s unamortized capitalized cost to the product’s net realizable value. To the extent unamortized capitalized cost exceeds net realizable value (based on the product’s estimated future gross revenues, less the estimated cost of revenue), the excess is written off. This analysis requires us to estimate future gross revenues associated with certain products, and the future cost of revenue. If these estimates change, write-offs of capitalized software costs could result.

Our business acquisitions typically result in the recognition of goodwill and other intangible assets, which affect the amount of current and future period charges and amortization expense. The determination of value of these components of a business combination, as well as associated asset useful lives, requires management to make various estimates and assumptions. Estimates using different, but each reasonable, assumptions could produce significantly different results.

On April 1, 2002 we adopted SFAS No. 142 “Accounting for Goodwill and Other Intangible Assets” (“SFAS No. 142”). SFAS No. 142 addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. In accordance with SFAS No. 142, goodwill is no longer amortized over its estimated useful life, rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test. We continually review the events and circumstances related to our financial performance and economic environment for factors that would provide evidence of impairment of goodwill. We test goodwill for impairment in accordance with SFAS 142 at least annually and more frequently upon the occurrence of certain events, as defined in SFAS 142. Goodwill is tested for impairment annually in a two-step process. First, we determine if the carrying amount exceeds “fair value” based on quoted market prices of our common stock, which would indicate that goodwill may be impaired. If we determine that goodwill may be impaired, we will compare the “implied fair value” of the goodwill, as defined by SFAS 142, to its carrying amount to determine the impairment loss, if any. Goodwill has resulted from our Ravisent product business acquisition

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during the first quarter ended June 30, 2002, from our DMD acquisition from VERITAS during the third quarter ended December 31, 2002, from our InterActual Technologies, Inc. acquisition during the fourth quarter ended March 31, 2004, and from our Roxio CSD acquisition during the third quarter ended December 31, 2004, all of which were accounted for as a purchase. As of December 31, 2004, no events have occurred that would lead us to believe that there has been any impairment.

On April 1, 2002, we adopted SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), which supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.” In accordance with SFAS 144, we evaluate long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. The amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. We do not have any long-lived assets which we consider to be impaired as of December 31, 2004.

OTHER DISCLOSURES

During the quarter ended June 30, 2003 we established a wholly owned subsidiary in Japan, called “Sonic Japan KK.” We transferred a total of 6 employees into this new subsidiary.

The new subsidiary was established because of the increased level of business we have encountered in Japan, to potentially lower our overall tax rate, and to increase our level of direct contact with important Japanese customers, particularly those OEM customers utilizing our consumer software products. As part of this reorganization, we began reorganizing the distribution of our software products in Japan. In July 2003, we notified Easy Systems Japan (“ESJ”), our prior Japanese distributor, of our intention to terminate its distributorship of some of our software products, and during the quarter ended September 30, 2004 we completed the transition of our business and customers from ESJ. While we believe that we have taken the necessary steps to ensure a smooth transition for ESJ’s customers, we may not be able to maintain our relationship with these customers in the future.

During the quarter ended September 30, 2003, we established a wholly owned subsidiary in China, called “Sonic Solutions Shanghai China,” and hired a number of engineers to work for this new subsidiary. We established this subsidiary in response to the growing demand for our CD/DVD creation technology worldwide. This new subsidiary allows us to tap into the large pool of engineering talent in China, speeding the development and deployment of our products and technologies to our customers. The subsidiary also brings additional reach to our operations which include development and sales offices in North America, Europe, Japan and Taiwan.

In connection with the Roxio CSD acquisition, we acquired wholly owned subsidiaries in Canada, Japan and the United Kingdom which provide engineering, technical support and sales and marketing services. Additionally, we acquired three dormant subsidiaries in France, Israel and the Cayman Islands. Two hundred and twelve former Roxio CSD employees joined our companies, of which one hundred and thirty-two currently work in our foreign offices.

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We are subject to various claims relating to products, technology, patent, shareholder and other matters. We are required to assess the likelihood of any adverse outcomes and the potential range of probable losses in these matters. The amount of loss accrual, if any, is determined after careful analysis of each matter, and is subject to adjustment if warranted.

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Results of Operations

The following table sets forth certain items from Sonic’s statements of operations as a percentage of net revenue for the quarters and nine months ended December 31, 2003 and 2004, respectively (in thousands):