UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2001
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
AND EXCHANGE ACT OF 1934
For the transition period from to
----------- -------------
Commission File Number 0-24363
Interplay Entertainment Corp.
(Exact name of the registrant as specified in its charter)
Delaware 33-0102707
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
16815 Von Karman Avenue, Irvine, California 92606
(Address of principal executive offices)
(949) 553-6655
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes[X] No[ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
Class Issued and Outstanding at November 12, 2001
----- -------------------------------------------
Common Stock, $0.001 par value 44,985,708
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
FORM 10-Q
SEPTEMBER 30, 2001
TABLE OF CONTENTS
--------------
Page Number
-----------
Part I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2001 (unaudited)
and December 31, 2000 3
Consolidated Statements of Operations for the Three and Nine Months
ended September 30, 2001 and 2000 (unaudited) 4
Consolidated Statements of Cash Flows for the Nine Months
ended September 30, 2001 and 2000 (unaudited) 5
Notes to Unaudited 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 34
Part II. Other Information
Item 1. Legal Proceedings 35
Item 3. Defaults Upon Senior Securities 35
Item 4. Submission of Matters to a vote of Security Holders 35
Item 6. Exhibits and Reports on Form 8-K 35
Signatures 36
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
ASSETS 2001 2000
------ ------------ ------------
(Unaudited)
Current Assets: (Dollars in thousands)
Cash $ 2,248 $ 2,835
Restricted cash 602 -
Trade receivables, net of allowances
of $8,642 and $6,543, respectively 3,071 28,136
Inventories 2,179 3,359
Prepaid licenses and royalties 11,297 17,704
Other 1,009 772
------------ ------------
Total current assets 20,406 52,806
Property and Equipment, net 5,441 5,331
Other Assets 1,137 944
------------ ------------
$ 26,984 $ 59,081
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
----------------------------------------------
Current Liabilities:
Current debt $ 8,070 $ 25,433
Accounts payable 14,871 12,270
Accrued liabilities 5,243 6,147
Royalty liabilities 10,136 7,258
Deferred income 12,603 1,575
------------ ------------
Total current liabilities 50,923 52,683
------------ ------------
Commitments and Contingencies (Notes 1 and 6)
Stockholders' Equity (Deficit) (Note 7):
Series A Preferred stock, $0.001 par value, authorized 5,000,000 shares;
issued and outstanding, 383,354 and 719,424 shares, respectively 11,634 20,604
Common stock, $0.001 par value, authorized 100,000,000 shares;
issued and outstanding 44,985,708 and 30,143,636 shares, respectively 45 30
Paid-in-capital 110,018 88,759
Accumulated deficit (145,791) (103,259)
Accumulated other comprehensive income 155 264
------------ ------------
Total stockholders' equity (deficit) (23,939) 6,398
------------ ------------
$ 26,984 $ 59,081
============ ============
The accompanying notes are an integral part of these consolidated
financial statements.
3
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months End Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2001 2000 2001 2000
------------ ------------ ------------ ------------
(Dollars in thousands, except per share amounts)
Net revenues $ 4,166 $ 31,631 $ 36,271 $ 73,828
Cost of goods sold 11,448 16,195 32,913 36,350
------------ ------------ ------------ ------------
Gross profit (7,282) 15,436 3,358 37,478
Operating expenses:
Marketing and sales 4,119 6,212 16,623 17,617
General and administrative 2,638 2,602 9,196 7,583
Product development 4,925 5,485 15,573 16,797
------------ ------------ ------------ ------------
Total operating expenses 11,682 14,299 41,392 41,997
------------ ------------ ------------ ------------
Operating (loss)/ income (18,964) 1,137 (38,034) (4,519)
Other expense:
Interest expense, net 1,011 710 2,607 2,266
Other expense, net 673 314 797 491
------------ ------------ ------------ ------------
Total other expense 1,684 1,024 3,404 2,757
------------ ------------ ------------ ------------
Net (loss)/income (20,648) 113 (41,438) (7,276)
------------ ------------ ------------ ------------
Cumulative dividend on participating preferred stock 228 300 828 570
Accretion of warrants on preferred stock - 200 266 333
------------ ------------ ------------ ------------
Net loss attributable to common stockholders $ (20,876) $ (387) $ (42,532) $ (8,179)
============ ============ ============ ============
Net loss per common share:
Basic and diluted $ (0.50) $ (0.01) $ (1.16) $ (0.27)
============ ============ ============ ============
Weighted average number of
common shares outstanding:
Basic and diluted 41,860,489 30,059,338 36,542,051 30,026,365
============ ============ ============ ============
The accompanying notes are an integral part of these consolidated
financial statements.
4
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30,
-------------------------
2001 2000
---------- ----------
Cash flows from operating activities: (Dollars in thousands)
Net loss $ (41,438) $ (7,276)
Adjustments to reconcile net loss to
cash provided by (used in) operating activities:
Depreciation and amortization 1,978 2,134
Write-off of prepaid royalties and licenses 8,124 -
Changes in assets and liabilities:
(Increase) decrease in trade receivables 25,015 (4,252)
Decrease in inventories 1,180 1,380
(Increase) decrease in prepaid licenses and royalties (1,717) 554
(Increase) decrease in other current assets (237) (157)
Increase (decrease) in accounts payable 2,601 (5,938)
(Decrease) in accrued liabilities (7,033) (723)
Increase (decrease) in deferred revenue 11,028 (313)
Additions to restricted cash (602) -
Increase (decrease) in royalty liabilities 2,878 (2,047)
---------- ----------
Net cash provided by (used in) operating activities 1,777 (16,638)
---------- ----------
Cash flows from investing activities:
Purchase of property and equipment (1,681) (2,662)
---------- ----------
Net cash used in investing activities (1,681) (2,662)
---------- ----------
Cash flows from financing activities:
Net borrowings (payments) on line of credit 4,878 (3,056)
Net payment of previous line of credit (24,433) -
Net payment of supplemental line of credit (1,000) -
Net proceeds from issuance of Series A Preferred Stock and warrants - 20,000
Net proceeds from issuance of common stock 11,847 323
Proceeds (payments) on notes payable 3,000 (375)
Proceeds from exercise of stock options 9 21
Reductions to restricted cash - 2,597
Advance from Titus for distribution agreement 1,000 -
Payment to Titus for cancellation of distribution agreement (1,000) -
Proceeds from other advances 5,000 -
Proceeds (payments) on other debt 125 (37)
---------- ----------
Net cash (used in) provided by financing activities (574) 19,473
---------- ----------
Effect of exchange rate changes on cash (109) (13)
---------- ----------
Net (decrease) increase in cash (587) 160
Cash, beginning of period 2,835 399
---------- ----------
Cash, end of period $ 2,248 $ 559
========== ==========
Supplemental cash flow information:
Cash paid for:
Interest $ 1,496 $ 2,303
Supplemental disclosures of Noncash transactions:
Acquisition of nine percent interest in Shiny $ 600 $ -
Accretion of preferred stock to redemption value 266 333
Dividend payable on partial conversion of preferred stock 721 -
Accrued dividend on participating preferred stock 828 570
The accompanying notes are an integral part of these consolidated
financial statements.
5
Note 1. Basis of Presentation
The accompanying interim consolidated financial statements of Interplay
Entertainment Corp. and its subsidiaries (the "Company") are unaudited and
reflect all adjustments (consisting only of normal recurring adjustments) that,
in the opinion of management, are necessary for a fair presentation of the
results for the interim period in accordance with instructions for Form 10-Q and
Rule 10-01 of Regulation S-X. Accordingly, they do not include all information
and footnotes required by generally accepted accounting principles in the United
States for complete financial statements. The results of operations for the
current interim period are not necessarily indicative of results to be expected
for the current year or any other period.
These consolidated financial statements should be read in conjunction
with the consolidated financial statements and notes thereto included in the
Company's annual report on Form 10-K for the year ended December 31, 2000 as
filed with the Securities and Exchange Commission.
Factors Affecting Future Performance and Going Concern
For the nine months ended September 30, 2001, the Company incurred a
net loss of $41.4 million. However, net cash provided by operating activities
was $1.8 million as the Company's negative operating results were largely offset
by strong trade receivable collections, the receipt of cash advances for
distribution rights and conservative management of inventories and
disbursements. During the same period last year, the net cash used in operating
activities was $16.6 million.
In April 2001, the Company secured a new $15.0 million line of credit
with a bank and completed the sale of $12.7 million of Common Stock in a private
placement transaction. The net proceeds of $11.9 million from the private
placement were used towards paying the outstanding balance under the Company's
previous bank line of credit which was expiring, and enabled the Company to
secure the new line of credit to fund ongoing operations (See Notes 4 and 7).
Advances under the new line of credit are limited to an amount based on
accounts receivable and inventories. The Company has not released sufficient
product during the three month period ended September 30, 2001 to generate a
profitable level of revenues, or sufficient accounts receivable to maximize the
use of its line of credit. The Company also anticipates that delays in product
releases could continue in the short-term, and funds available under its new
line of credit and from ongoing operations are not sufficient to satisfy the
projected working capital and capital expenditure needs in the normal course of
business. In addition, the Company is not in compliance with certain financial
covenants set forth in the new line of credit agreement as of September 30,
2001. In October 2001, the bank notified the Company that the credit agreement
was being terminated, the outstanding balance is currently due and payable and
the Company would no longer be able to continue to draw on the credit facility
to fund future operations effective October 26, 2001. The Company and the bank
are currently negotiating the payment of the outstanding balance which is
approximately $2.7 million on November 9, 2001 (See Note 4).
During the three months ended September 30, 2001, the Company entered
into two distribution agreements. In connection with the North American
distribution rights of a future title, the Company received an advance of $4.0
million. The Company entered into a distribution agreement with Vivendi
Universal Interactive Publishing ("Vivendi"), a related party, for the Company's
North American distribution rights and received a $10.0 million advance in
connection with the distribution agreement (See Note 11). The advances will be
recouped against future distribution commissions payable, based on the future
sales and have been included in deferred income (See Note 5).
The Company continues to implement cost reduction programs and is
seeking external sources of funding, including but not limited to, a sale or
merger of the Company, a private placement of Company capital stock, the sale of
selected assets, the licensing of certain product rights in selected
territories, selected distribution agreements, and/or other strategic
transactions sufficient to provide short-term funding, and potentially carry out
management's long-term strategic objectives. However, there can be no assurance
that the Company can complete the transactions necessary to provide the required
funding on a timely basis in order to continue ongoing operations in the normal
course of business.
If the Company is unable to secure the required funding on a timely
basis, it will need to continue to reduce its costs by selling or consolidating
its operations, and by continuing to delay or cancel product development and
marketing programs. These measures could have a material adverse effect on the
Company's ability to continue as a going concern.
6
In addition to the continuing risks related to the Company's future
liquidity, the Company also faces numerous other risks associated with its
industry. These risks include dependence on new platform introductions by
hardware manufacturers, commercially successful new product introductions by the
Company, new product introduction delays, rapidly changing technology, intense
competition, dependence on distribution channels and risk of customer returns.
The Company's consolidated financial statements have been presented on
the basis that the Company is a going concern. Accordingly, the consolidated
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amounts and
classification of liabilities or any other adjustments that might result should
the Company be unable to continue as a going concern.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Reclassifications
Certain reclassifications have been made to the prior period's
financial statements to conform to classifications used in the current period.
Restricted Cash
Restricted cash represents cash deposited in an escrow account made in
accordance with the distribution agreement between the Company and Vivendi. The
escrow account was established to provide for the payment of Directors and
Officers liability insurance for events occurring subsequent to August 13, 2001,
the payment of Directors and Officers liability insurance for events occurring
prior to August 13, 2001 and payment of certain outside legal counsel invoices.
As of September 30, 2001 only funds for the Directors and Officers liability
insurance for events occurring subsequent to August 13, 2001 were released.
Subsequent to September 30, 2001, the Company released the funds for payment of
the Directors and Officers liability insurance for events occurring prior to
August 13, 2001 (See Note 11).
Prepaid Licenses and Royalties
Prepaid licenses and royalties consist of payments for intellectual
property rights and advanced royalty payments to outside developers. Such costs
include certain other outside production costs generally consisting of film cost
and amounts paid for digitized motion data with alternative future uses.
Payments to developers represent contractual advanced payments made for future
royalties. These payments are contingent upon the successful completion of
milestones, which generally represent specific deliverables. Royalty advances
are recoupable against future sales based upon the contractual royalty rate. The
Company amortizes the cost of licenses, prepaid royalties and other outside
production costs to cost of goods sold over six months commencing with the
initial shipment of the related title at a rate based upon the number of units
shipped. Management evaluates the future realization of such costs quarterly by
reviewing the forecasted sales of the future titles in development. When a title
is an externally developed title and the Company is paying royalty advances to
the third party developer, the Company compares the forecasted net proceeds
after selling costs to the amount capitalized. If the amount of net proceeds is
greater than the amount capitalized, the advance on royalties is not considered
to be impaired. If the amount capitalized is greater than the amount of net
proceeds, the advance is considered impaired and the amount capitalized in
excess of forecasted net proceeds is charged to cost of goods sold. Such costs
are classified as current and noncurrent assets based upon estimated net product
sales.
Royalty Liabilities
Royalty liabilities consist of amounts due to outside developers based
on contractual royalty rates for sales of shipped titles. The Company records a
royalty expense based upon a contractual royalty rate after it has fully
recouped the royalty advances paid to the outside developer, if any, prior to
shipping a title. Royalty liabilities also include unearned advances received by
the Company from console hardware and software manufacturers for the development
of titles for their console platforms.
Revenue Recognition
Revenues are recorded when products are delivered to customers in
accordance with Statement of Position ("SOP") 97-2, "Software Revenue
Recognition". For those agreements that provide the customers the right to
7
multiple copies in exchange for guaranteed amounts, revenue is recognized at the
delivery of the product master or the first copy. Per copy royalties on sales
that exceed the guarantee are recognized as earned. Guaranteed minimum royalties
on sales that do not meet the guarantee are recognized as the minimum payments
come due. The Company is generally not contractually obligated to accept
returns, except for defective, shelf-worn and damaged products in accordance
with negotiated terms. However, the Company permits customers to return or
exchange product and may provide price protection on products unsold by a
customer. In accordance with Statement of Financial Accounting Standards
("SFAS") No. 48, "Revenue Recognition when Right of Return Exists," revenue is
recorded net of an allowance for estimated returns, exchanges, markdowns, price
concessions, and warranty costs. Such reserves are based upon management's
evaluation of historical experience, current industry trends and estimated
costs. The amount of reserves is an estimate and the amount ultimately required
could differ materially in the near term from the amounts included in the
accompanying consolidated financial statements. Customer support provided by the
Company is limited to telephone and Internet support. These costs are not
material and are charged to expense as incurred.
Recent Accounting Pronouncements
In April 2001, the Emerging Issues Task Force issued No. 00-25 ("EITF
00-25"), "Accounting for Consideration from a Vendor to a Retailer in Connection
with the Purchase or Promotion of the Vendor's Products", which states that
consideration from a vendor to a reseller of the vendor's products is presumed
to be a reduction of the selling prices of the vendor's products and, therefore,
should be characterized as a reduction of revenue when recognized in the
vendor's income statement. That presumption is overcome and the consideration
can be categorized as a cost incurred if, and to the extent that, a benefit is
or will be received from the recipient of the consideration. That benefit must
meet certain conditions described in EITF 00-25. The consensus should be applied
no later than in annual or interim financial statements for periods beginning
after December 15, 2001. The Company is currently evaluating the impact of this
consensus on its Statement of Operations.
In June 2001, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other
Intangible Assets" effective for fiscal years beginning after December 15, 2001.
Under the new rules all acquisition transactions entered into after June 30,
2001, must be accounted for on the purchase method and goodwill will no longer
be amortized but will be subject to annual impairment tests in accordance with
SFAS 142. Other intangible assets will continue to be amortized over their
useful lives. The Company will apply the new rules on accounting for goodwill
and other intangible assets beginning in the first quarter of 2002. The Company
will perform the first of the required impairment tests of goodwill as of
January 1, 2002 and has not yet determined what the effect of these tests will
be on the earnings and financial position of the Company.
In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No.
143, "Accounting for Asset Retirement Obligations." SFAS No. 143 addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. The provisions of SFAS No. 143 are effective for financial statements
issued for fiscal years beginning after June 15, 2002, with early application
encouraged and generally are to be applied prospectively. The Company does not
expect the adoption of SFAS No. 143 to have a material impact on its financial
position or results of operations.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and the
accounting and reporting provisions of APB Opinion No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," for the disposal of a segment of a business (as previously
defined in that Opinion). The provisions of SFAS No. 144 are effective for
financial statements issued for fiscal years beginning after December 15, 2001,
with early application encouraged and generally are to be applied prospectively.
The Company does not expect the adoption of SFAS No. 144 to have a material
impact on its financial position or results of operations.
8
Note 2. Inventories
Inventories consist of the following:
September 30, December 31,
2001 2000
---------- ----------
(Dollars in thousands)
Packaged software $ 1,853 $ 2,628
CD-ROMs, cartridges, manuals, packaging and supplies 326 731
---------- ----------
$ 2,179 $ 3,359
========== ==========
Note 3. Prepaid licenses and royalties
Prepaid licenses and royalties are as follows:
September 30, December 31,
2001 2000
---------- ----------
(Dollars in thousands)
Prepaid royalties for titles in development $ 8,814 $ 9,254
Prepaid royalties for shipped titles, net of amortization 144 6,174
Prepaid licenses and trademarks, net of amortization 2,339 2,276
---------- ----------
$ 11,297 $ 17,704
========== ==========
During the three and nine months ended September 30, 2001, the Company
expensed $5.9 million and $8.1 million, respectively, for prepaid royalties that
were impaired due to the cancellation of certain development projects. No
amounts were written-off during the three and nine month periods ended September
30, 2000.
Note 4. Current Debt
Current debt consists of the following:
September 30, December 31,
2001 2000
---------- ----------
(Dollars in thousands)
Working capital line of credit $ 4,878 $ 24,433
Loan from Chairman and Chief Executive Officer 3,142 -
Supplemental line of credit from Titus - 1,000
Other 50 -
---------- ----------
$ 8,070 $ 25,433
========== ==========
Working Capital Line of Credit
In April 2001, the Company entered into a new three year loan and
security agreement ("L&S Agreement") with a bank providing for a $15.0 million
working capital line of credit. The L&S Agreement replaced an agreement with a
former bank that expired. The expired line of credit bore an interest rate of
LIBOR (6.78 percent at December 31, 2000) plus 4.87 percent (11.65 percent at
December 31, 2000). In April 2001, all amounts outstanding to the former Bank
were paid in full. Advances under the new line of credit are limited to an
amount based on qualified accounts receivable and inventory. The new line bears
interest at the bank's prime rate, or, at the Company's option, a portion of the
outstanding balance would bear interest at LIBOR plus 2.5% for a fixed short-
term. At September 30, 2001, borrowings under the working capital line of credit
bore interest at various interest rates ranging between 6.00 percent and 6.18
percent.
The line is subject to review and renewal by the bank on April 30, 2002 and
2003, and is secured by substantially all of the Company's assets, plus a
personal guarantee of $2.0 million from the Chairman, secured by $1.0 million in
cash (See Note 7). The line requires that the Company meet certain financial
covenants set forth in the agreement. The Company is not in compliance with
certain of these covenants, including the financial covenants related to net
worth and minimum earnings before interest, taxes, depreciation and amortization
and recent agreements with Titus and Vivendi; as of September 30, 2001. In
October 2001, the bank notified the Company that the L&S Agreement was being
terminated, all outstanding amounts are currently due and payable and the
Company must comply with all requirements in the L&S Agreement with respect to
collateral, including, but not limited to, not disposing of collateral except in
the ordinary course of business and not moving same from its current locations
except in strict accordance with the L&S Agreement and the Company would no
longer be able to continue to draw on the credit facility to fund future
operations. In furtherance of the bank's notification with respect to
collateral, the bank informed the Company that upon any transfer of inventory
or other collateral to Vivendi, the bank must be paid for the portion of the
loan balance that is secured by any inventory that is transferred. The Company
and the bank are currently negotiating the payment of the outstanding amounts.
As a result of the L&S Agreement being terminated, the interest rate on the
outstanding balance increased two percent over the original interest rate.
Because the Company depends on proceeds from its credit
9
agreement to fund its operations, and the Company does not have the funds to pay
the outstanding balance, the termination of the credit agreement and the
acceleration of payment by the bank could have a material adverse effect on the
Company's ability to continue as a going concern (See Note 1).
Loan from Chairman and Chief Executive Officer
In April 2001, the Chairman provided the Company with a $3.0 million
loan, payable in May 2002, with interest at 10.0 percent (See Note 7).
Supplemental line of credit from Titus
In April 2000, the Company secured a $5.0 million supplemental line of
credit with Titus Interactive SA ("Titus"), a major shareholder of the Company,
expiring in May 2001. In connection with this line of credit, Titus received a
warrant exercisable for 60,298 shares of the Company's Common Stock at $3.79 per
share that will expire in April 2010. As of September 30, 2001, Titus has not
exercised these warrants. In April 2001, the total outstanding balance plus
accrued interest in the aggregate amount of approximately $3.1 million was paid
in full and the commitment under the supplemental line of credit was terminated.
Note 5. Deferred Income
Deferred income consists of advances from distribution agreements and
advances for product currently in development. The advances from distribution
agreements will be recouped against future distribution commissions payable,
based on the future sales and advances for product in development are recouped
upon shipment of the title to the customer. In the event the Company does not
perform its obligations under the distribution agreements, the Company would be
obligated to refund any advances not recouped against.
Deferred income consists of the following:
September 30, December 31,
2001 2000
---------- ----------
(Dollars in thousands)
Advance from Vivendi for North American distribution rights $ 5,000 $ -
Advances for distribution rights to a future title 4,000 -
Advances for certain distribution rights in Asia 2,230 -
Advances for other distribution rights 1,292 1,429
Advances for future titles in development 81 146
---------- ----------
$ 12,603 $ 1,575
========== ==========
Note 6. Commitments and Contingencies
The Company and the former owner of the Company's wholly-owned
subsidiary Shiny Entertainment ("Shiny") had a dispute over cash payments upon
the delivery and acceptance of interactive entertainment software titles that
Shiny was committed to deliver over time. In March 2001, the Company entered
into an amendment to the Shiny purchase agreement which, among other things,
settled the dispute with the former owner of Shiny, and provided for the Company
to acquire the remaining nine percent equity interest in Shiny for $600,000
payable in installments of cash and stock. The amendment also provided for
additional cash payments to the former owner of Shiny for two interactive
entertainment software titles to be delivered in the future. The former owner of
Shiny will earn royalties after the future delivery of the two titles to the
Company. At September 30, 2001, the Company owed the former owner of Shiny
$50,000.
Virgin Interactive Entertainment Limited ("Virgin"), whose ultimate
parent is Titus, had disputed an amendment to the International Distribution
Agreement with the Company, and claimed that the Company was obligated, among
other things, to pay a contribution to their overhead of up to $9.3 million
annually, subject to reductions by the amount of commissions earned by Virgin on
its distribution of the Company's products. In April 2001, the Company settled
this dispute with Virgin, and further amended the International Distribution
Agreement and amended the Termination Agreement and the Product Publishing
Agreement, all of which were entered into on February 10, 1999 when the Company
acquired an equity interest in Virgin's parent company VIE Acquisition Group LLC
("VIE"). As a result of the settlement, Virgin dismissed its claim for overhead
fees, VIE fully redeemed the Company's membership interest in
10
VIE and Virgin paid the Company $3.1 million in net past due balances owed under
the International Distribution Agreement. In addition, the Company will pay
Virgin a one-time marketing fee of $333,000 for the period ending June 30, 2001
and the monthly overhead fee was revised for the Company to pay $111,000 per
month for the nine month period beginning April 2001, and $83,000 per month for
the six month period beginning January 2002, with no further overhead commitment
for the remainder of the term of the International Distribution Agreement. The
Company no longer has an equity interest in VIE or Virgin as of April 2001.
In March 2001, the Company entered into a supplement to a licensing
agreement with a console hardware and software manufacturer under which it
received an advance of $5.0 million. The advance is to be repaid at $20 per unit
upon the sale of product under this agreement, as defined. If the full amount of
the advance is not paid by June 2003, then the remaining outstanding balance is
subject to interest at the prime rate plus one percent. This advance has been
included in royalty liabilities on the accompanying consolidated balance sheet.
Some of the Company's license, development and distribution agreements
contain provisions that allow the other party to terminate the agreement upon a
change in control of the Company. Titus recently converted a portion of its
Preferred Stock into Common Stock, which as of November 9, 2001 gave Titus 52
percent of the Company's total voting power. At the 2001 annual stockholders
meeting on September 18, 2001, Titus exercised its voting power to elect a
majority of the Board of Directors. Some of the Company's third-party developers
and licensors may assert that these events constitute a change in control of the
Company and attempt to terminate their respective agreements with the Company.
In particular, the license for "the Matrix" allows for the licensor to terminate
the license if there is a substantial change of ownership or control without
their approval. The agreements with Microsoft ancillary to the Xbox license
require, among other things, that the Company continues development of the
Matrix product, and that credit agreement with LaSalle is maintained. Microsoft
may consider the potential for termination of the Matrix license and the current
non-compliances with the LaSalle credit agreement to be of sufficient
materiality to require repayment of the advance. The loss of the Matrix license
would materially harm the Company's projected operating results and financial
condition.
The Company is involved in a dispute with one of its third party
developers. The third party developer alleges that the Company has underpaid the
third party developer for royalties due on sales of products developed by the
third party developer and sold by the Company. The Company believes that the
claims are without merit and will vigorously defend its position.
Note 7. Stockholders' Equity
In April 2001, the Company completed a private placement of 8,126,770
shares of Common Stock for $12.7 million, and received net proceeds of
approximately $11.9 million. The shares were issued at $1.5625 per share, and
included warrants to purchase one share of Common Stock for each share sold. The
warrants are exercisable at $1.75 per share of common stock, and can be
exercised immediately. If the Company issues additional shares of Common Stock
at a per share price below the exercise price of the warrants, then the warrants
are to be repriced, as defined, subject to stockholder approval. The warrants
expire in March 2006. In addition to the warrants issued with the private
placement, the Company granted the investment banker associated with the
transaction a warrant for 500,000 shares of the Company's Common Stock. The
warrant has an exercise price of $1.5625 per share and vests one year after the
registration statement for the shares of Common Stock issued under the private
placement becomes effective. The warrant expires four years after it vests. The
transaction provides for registration rights with a registration statement to be
filed by April 16, 2001 and become effective by May 31, 2001. The effective date
of the registration statement was not met and the Company is incurring a two
percent penalty per month, payable in cash, until the effectiveness of the
registration. This obligation will continue to accrue each month that the
registration statement is not declared effective and does not have a limit on
the amount payable to these stockholders. Because the payment for non-compliance
is cumulative, such obligation could have a material adverse effect on the
financial condition of the Company. Moreover, the Company may be unable to pay
these stockholders the amount of money due to them. During the three and nine
month period ended September 30, 2001 the Company accrued $0.8 million and $1.0
million, respectively, payable to these stockholders, which was charged to
results of operations and classified as other expense.
In April 2001, the Chairman provided the Company with a $3.0 million
loan, payable in May 2002. In connection with this loan to the Company and the
Chairman's $2.0 million personal guarantee of the Company's new credit facility
(See Note 4), the Chairman received warrants to purchase 500,000 shares of the
Company's Common Stock at $1.75 per share and vested upon issuance, expiring in
April 2004.
In August 2001, Titus converted 336,070 shares of Series A Preferred
Stock into 6,679,306 shares of Common Stock. The Preferred Stock accrues a six
percent cumulative dividend per annum payable in cash or, at the option of
Titus, in shares of the Company's Common Stock as declared by the Company's
Board of Directors. This conversion did not include accumulated dividends of
$721,000 on the Preferred Stock and were recorded as an accrued liability as
Titus has elected to receive the dividends in cash. Subsequent to this partial
conversion, Titus now owns 19,496,561 shares of Common Stock and 383,354 shares
of Series A Preferred Stock with voting rights equivalent to 4,059,903 shares of
Common Stock. Collectively, Titus has 52 percent of the total voting power of
the Company's capital stock as of November 7, 2001.
In September 2001, Titus retained Europlay I, LLC ("Europlay") as
consultants to assist with the restructuring of the Company. Since the
arrangements with Europlay are currently with Titus and Europlay's services have
a direct benefit to the Company, the Company has recorded an expense and a
capital contribution by Titus of $75,000 for the three months ended September
30, 2001 in accordance with the SEC's Staff Accounting Bulletin No. 79
"Accounting for Expenses and Liabilities Paid by Principal Stockholders."
Note 8. General and Administrative Expenses
Included in general and administrative expenses for the nine months
ended September 30, 2001 were a $0.6 million provision for the termination of a
building lease in the United Kingdom and $0.5 million in legal, accounting and
investment banking fees and expenses incurred principally in connection with the
efforts of a proposed sale of the Company which has been terminated.
Note 9. Net Loss Per Share
Basic net loss per share is calculated by dividing net loss available
to common stockholders by the weighted average number of common shares
outstanding and does not include the impact of any potentially dilutive
securities. Diluted net loss per share is the same as basic net loss per share
because the effect of outstanding stock options and warrants is anti-dilutive.
11
There were options and warrants outstanding to purchase 13,900,339 and
4,234,558 shares of Common Stock at September 30, 2001 and 2000, respectively,
which were excluded from the loss per share computation as they were
antidulitive. At September 30, 2000, there were 484,848 shares of restricted
Common Stock that were excluded from the loss per share computation as they were
antidulitive. The weighted average exercise price of the outstanding options and
warrants at September 30, 2001 and 2000 was $2.12 and $2.97, respectively.
Note 10. Comprehensive Loss
Comprehensive loss consists of the following:
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
2001 2000 2001 2000
---------- ---------- ---------- ----------
(Dollars in thousands)
Net loss $ (20,648) $ 113 $ (41,438) $ (7,276)
Other comprehensive loss, net of income taxes:
Foreign currency translation adjustments (63) (16) (109) (13)
---------- ---------- ---------- ----------
Total comprehensive loss $ (20,711) $ 97 $ (41,547) $ (7,289)
========== ========== ========== ==========
During the three and nine months ended September 30, 2001 and 2000, the
net effect of income taxes on comprehensive loss was immaterial.
Note 11. Related Parties
Distribution and Publishing Agreements
In connection with the amended International Distribution Agreement
with Virgin, the Company incurred distribution commission expense of $482,000
and $1.1 million for the three months ended September 30, 2001 and 2000 and $1.1
million and $2.5 million for the nine months ended September 30, 2001 and 2000,
respectively. In addition, the distribution agreement cannot be terminated
without incurring penalties of a minimum of $10.0 million, subject to
substantial increases pursuant to the terms of the distribution agreement, which
may discourage potential acquirors that already have their own distribution
capabilities in territories covered by the distribution agreement.
In connection with the Product Publishing Agreement with Virgin, the
Company earned $21,000 and $171,000 for performing publishing and distribution
services on behalf of Virgin during the three months ended September 30, 2001
and 2000 and $36,000 and $346,000 during the nine months ended September 30,
2001 and 2000, respectively. As part of the terms of the April 2001 settlement
between Virgin and the Company, the Product Publishing Agreement was amended to
provide for the Company to publish only one future title developed by Virgin
(see Note 5).
As of September 30, 2001 and December 31, 2000, Virgin owed the Company
$0.9 million and $12.1 million and the Company owed Virgin $0.9 million and $4.8
million, respectively. The net amounts due to the Company from Virgin as of
December 31, 2000, were paid in full in April 2001.
The Company performs distribution services on behalf of Titus for a
fee. In connection with such distribution services during the three months ended
September 30, 2001 and 2000, the Company did not recognize any distribution fee
revenue. During the nine months ended September 30, 2001 and 2000, the Company
earned $25,000 and $442,000, respectively.
As of September 30, 2001 and December 31, 2000, Titus owed the Company
$259,000 and $280,000 and the Company owed Titus $193,000 and $1.1 million,
respectively, including amounts owed under the supplemental line of credit (See
Note 4).
In August 2001, the Company entered into a distribution agreement with
Vivendi providing for Vivendi to become the Company's distributor in North
America for substantially all of its products, with the exception of products
with pre-existing distribution agreements, through December 31, 2003. OEM rights
were not among the rights granted to Vivendi under the Distribution Agreement.
Under the terms of the agreement, Vivendi will earn a 15 percent commission,
however, to accelerate the recoupment of the $10.0 million advance, Vivendi
will initially earn a 20 percent commission. The agreement provides for three
advance payments from Vivendi totaling $10.0 million in the aggregate. The
Company received payment from Vivendi upon the completion of the following
milestones. The first payment of $1.0 million was received once the Company's
Board of Directors approved the Distribution Agreement. The second payment of
$4.0 million, which was placed in an escrow account, was due once the Company
received approval from the Company's bank. This requirement was later removed
and the funds were released to the Company. The final payment of $5.0 million
was paid to the Company upon delivery of the approved master copy of Baldur's
Gate: Dark Alliance. This was delivered to Vivendi subsequent to September 30,
2001. The Company received two payments totaling $5.0 million during September
2001 and the final payment of $5.0 million was received in October 2001.
12
As a result of engaging Vivendi as the Company's North America
distributor, the Company now distributes substantially all of its products
through third-party distributors. The Company has therefore substantially
discontinued its internal product distribution capacity, including its sales and
marketing capacity. Following this change, the Company has re-oriented its
business towards product development and publishing. As a result of entering
into the distribution agreement with Vivendi, the Company has substantially
increased its provision for accounts receivable due to granting certain price
concessions on prior sales to minimize future returns following the transition
of the Company's distribution to Vivendi. Subsequent to September 30, 2001, the
Company reduced its headcount by approximately 15 percent by eliminating
redundant positions created by the distribution agreement.
Investment in Affiliate
The Company accounted for its investment in VIE in accordance with the
equity method of accounting. The Company did not recognize any material income
or loss in connection with its investment in VIE for the three and nine months
ended September 30, 2001 and 2000. In April 2001, VIE fully redeemed the
Company's membership interest in VIE in connection with the April 2001
settlement between Virgin and the Company. The Company no longer has an equity
interest in VIE or Virgin as of April 2001.
Events with Titus
Titus, the Company's largest stockholder, recently gained a majority of
the Company's stockholders' voting power, providing Titus with the ability to
control the outcome of votes on proposals presented to the Company's
stockholders, as well as the ability to elect a majority of the Company's
directors. The events relating to Titus' gaining of majority voting power are as
follows:
o On September 5, 2001, the Company entered into a Support
Agreement with Titus providing for the nomination to the
Company's Board of Directors a slate of six individuals
mutually acceptable to Titus and the Company for election as
directors at the Company's 2001 annual meeting of
stockholders, and appointing a Chief Administrative Officer
("CAO") to the Company. Also on September 5, 2001, as part of
the Support Agreement, three of the existing directors
resigned and three new directors acceptable to Titus were
appointed by the remaining directors to fill the three
vacancies. As a consequence, from September 6, 2001 until the
2001 annual meeting, the Board of Directors consisted of five
individuals nominated by Titus, and two directors previously
nominated by management.
o On September 13, 2001, the Company's Board of Directors
established an Executive Committee, consisting of the
Company's President and CAO, to administer and oversee all
aspects of the Company's day-to-day operations, including,
without limitation, (a) the relationship with lenders,
including LaSalle Business Credit, Inc.; (b) relations with
Europlay, consultants retained to effect the restructuring of
the Company (See Note 7); (c) capital raising efforts; (d)
relationships with vendors and licensors; (e) management of
employment of officers and employees; (f) retaining and
managing outside professionals and consultants; and (g)
directing management.
o The Company's 2001 annual meeting was held on September 18,
2001. At the annual meeting, the five Titus nominees, and one
of the directors previously nominated by management, were
elected to continue to serve as directors. The Company
currently has one vacancy on its Board of Directors.
On September 13, 2001, the Company orally agreed to sell to Titus
distribution rights to its products in the territories of Australia, New Zealand
and Asia. Because of Titus' relationship with the Company, the sale of the
properties was conditional upon approval of the transaction by a committee of
the Company's Board of Directors comprised of disinterested directors. The
transaction was also conditional upon the completion by Titus of its due
diligence on the properties. Titus advanced $1.0 million to the Company to be
held as a good faith deposit against the purchase price pending approval by the
Board committee and completion by Titus of its due diligence. If the agreement
was not consummated, Titus would be entitled to a breakup fee of 0.25 percent
per week the Company held the $1.0 million deposit. The Board committee did not
approve the transaction, and Titus elected not to purchase the properties
following completion of its due diligence. As a consequence, the parties
terminated the agreement and on September 26, 2001 the $1.0 million deposit was
returned to Titus and Titus waived the breakup fee.
In September 2001, Titus retained Europlay as consultants to assist
with the restructuring of the Company. Since the arrangements with Europlay are
currently with Titus and Europlay's services have a direct benefit to the
Company, the Company has recorded an expense and a capital contribution by Titus
of $75,000 for the three months ended September 30, 2001. The Company plans to
enter into a new consulting agreement with Europlay which would replace the
agreement between Titus and Europlay.
13
Note 12. Segment and Geographical Information
The Company operates in one principal business segment. Information
about the Company's operations in the United States and foreign markets is
presented below:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- -------------------------
2001 2000 2001 2000
---------- ---------- ---------- ----------
Net revenues: (Dollars in thousands)
United States $ 4,166 $ 31,456 $ 36,271 $ 73,605
United Kingdom - 175 - 223
---------- ---------- ---------- ----------
Consolidated net revenues $ 4,166 $ 31,631 $ 36,271 $ 73,828
========== ========== ========== ==========
Operating income (loss):
United States $ (18,517) $ 1,123 $ (36,527) $ (4,005)
United Kingdom (447) 14 (1,507) (514)
---------- ---------- ---------- ----------
Consolidated income (loss) from operations $ (18,964) $ 1,137 $ (38,034) $ (4,519)
========== ========== ========== ==========
Expenditures made for the acquisition
of long-lived assets:
United States $ 598 $ 1,044 $ 1,659 $ 2,605
United Kingdom 4 15 22 58
---------- ---------- ---------- ----------
Total expenditures for
long-lived assets $ 602 $ 1,059 $ 1,681 $ 2,663
========== ========== ========== ==========
Net revenues by geographic regions were as follows:
Three Months Ended September 30, Nine Months Ended September 30,
---------------------------------------------- ----------------------------------------------
2001 2000 2001 2000
---------------------- --------------------- --------------------- ---------------------
Amount Percent Amount Percent Amount Percent Amount Percent
---------- ------- ---------- ------- ---------- ------- ---------- -------
(Dollars in thousands)
North America $ 1,110 26.6 % $ 19,376 61.3 % $ 25,331 69.8 % $ 41,896 56.7 %
Europe 1,888 45.3 5,925 18.7 5,608 15.5 15,624 21.2
Rest of World 344 8.3 2,715 8.6 1,690 4.7 5,154 7.0
OEM, royalty and
licensing 824 19.8 3,615 11.4 3,642 10.0 11,154 15.1
---------- ------- ---------- ------- ---------- ------- ---------- -------
$ 4,166 100.0 % $ 31,631 100.0 % $ 36,271 100.0 % $ 73,828 100.0 %
========== ======= ========== ======= ========== ======= ========== =======
Net investments in long-lived assets by geographic regions were as
follows:
September 30, December 31,
2001 2000
------------------- -------------------
Amount Percent Amount Percent
-------- ------- -------- -------
(Dollars in thousands)
United States $ 6,441 97.9 % $ 6,139 97.8 %
United Kingdom 82 1.3 76 1.2
OEM, royalty and
licensing 55 0.8 60 1.0
-------- ------- -------- -------
$ 6,578 100.0 % $ 6,275 100.0 %
======== ======= ======== =======
14
[This page intentionally left blank]
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Cautionary Statement
The information contained in this Form 10-Q is intended to update the
information contained in the Company's Annual Report on Form 10-K for the year
ended December 31, 2000 and presumes that readers have access to, and will have
read, the "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and other information contained in such Form 10-K.
This Form 10-Q contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities and Exchange Act of 1934 and such forward-looking statements are
subject to the safe harbors created thereby. For this purpose, any statements
contained in this Form 10-Q, except for historical information, may be deemed to
be forward-looking statements. Without limiting the generality of the foregoing,
words such as "may," "will," "expect," "believe," "anticipate," "intend,"
"could," "should," "estimate" or "continue" or the negative or other variations
thereof or comparable terminology are intended to identify forward-looking
statements. In addition, any statements that refer to expectations, projections
or other characterizations of future events or circumstances are forward-looking
statements.
The forward-looking statements included herein are based on current
expectations that involve a number of risks and uncertainties, as well as on
certain assumptions. For example, any statements regarding future cash flow,
financing activities, cost reduction measures, compliance with the Company's
line of credit and an extension or replacement of such line are forward-looking
statements and there can be no assurance that the Company will achieve its
operating plans, generate positive cash flow in the future or that the Company
will be able to maintain or replace its current financing arrangements or
complete strategic transactions on satisfactory terms, if at all, or that any
cost reductions effected by the Company will be sufficient to offset any
negative cash flow from operations. Additional risks and uncertainties include
possible delays in the completion of products, the possible lack of consumer
appeal and acceptance of products released by the Company, fluctuations in
demand for the Company's products, lost sales because of the rescheduling of
products launched or orders delivered, failure of the Company's markets to
continue to grow, that the Company's products will remain accepted within their
respective markets, that competitive conditions within the Company's markets
will not change materially or adversely, that the Company will retain key
development and management personnel, that the Company's forecasts will
accurately anticipate market demand and that there will be no material adverse
change in the Company's operations or business. Additional factors that may
affect future operating results are discussed in more detail in "Factors
Affecting Future Performance" below as well as the Company's Annual Report on
Form 10-K on file with the Securities and Exchange Commission. Assumptions
relating to the foregoing involve judgments with respect to, among other things,
future economic, competitive and market conditions, and future business
decisions, all of which are difficult or impossible to predict accurately and
many of which are beyond the control of the Company. Although the Company
believes that the assumptions underlying the forward-looking statements are
reasonable, the business and operations of the Company are subject to
substantial risks that increase the uncertainty inherent in the forward-looking
statements, and the inclusion of such information should not be regarded as a
representation by the Company or any other person that the objectives or plans
of the Company will be achieved. In addition, risks, uncertainties and
assumptions change as events or circumstances change. The Company disclaims any
obligation to publicly release the results of any revisions to these
forward-looking statements which may be made to reflect events or circumstances
occurring subsequent to the filing of this Form 10-Q with the SEC or otherwise
to revise or update any oral or written forward-looking statement that may be
made from time to time by or on behalf of the Company.
16
Results of Operations
The following table sets forth certain selected consolidated statements
of operations data, segment data and platform data for the periods indicated in
dollars and as a percentage of total net revenues:
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------------------- ----------------------------------------
2001 2000 2001 2000
------------------- -------------------- ------------------- -----------------
% of Net % of Net % of Net % of Net
Amount Revenues Amount Revenues Amount Revenues Amount Revenues
-------- -------- --------- -------- -------- -------- -------- --------
(Dollars in thousands)
Net revenues $ 4,166 100.0% $ 31,631 100.0% $ 36,271 100.0% $ 73,828 100.0%
Cost of goods sold 11,448 274.8% 16,195 51.2% 32,913 90.7% 36,350 49.2%
-------- ------ -------- ------ -------- ------ -------- ------
Gross profit (7,282) -174.8% 15,436 48.8% 3,358 9.3% 37,478 50.8%
-------- ------ -------- ------ -------- ------ -------- ------
Operating expenses:
Marketing and sales 4,119 98.9% 6,212 19.6% 16,623 45.8% 17,617 23.9%
General and administrative 2,638 63.3% 2,602 8.2% 9,196 25.4% 7,583 10.3%
Product development 4,925 118.2% 5,485 17.3% 15,573 42.9% 16,797 22.8%
-------- ------ -------- ------ -------- ------ -------- ------
Total operating expenses 11,682 280.4% 14,299 45.1% 41,392 114.1% 41,997 57.0%
-------- ------ -------- ------ -------- ------ -------- ------
Operating (loss) income (18,964) -455.3% 1,137 3.7% (38,034) -104.8% (4,519) -6.2%
Other expense 1,684 40.4% 1,024 3.2% 3,404 9.4% 2,757 3.7%
-------- ------ -------- ------ -------- ------ -------- -----
Net (loss) income $(20,648) -495.6% $ 113 0.5% $(41,438) -114.2% $ (7,276) -9.9%
======== ======= ======== ====== ======== ======= ======== ======
Net revenues by geographic region:
North America $ 1,110 26.6% $ 19,376 61.3% $ 25,331 69.9% $ 41,896 56.7%
International 2,232 53.6% 8,640 27.3% 7,298 20.1% 20,778 28.2%
OEM, royalty and licensing 824 19.8% 3,615 11.4% 3,642 10.0% 11,154 15.1%
Net revenues by platform:
Personal computer $ 3,041 73.0% $ 23,814 75.3% $ 28,061 77.4% $ 51,393 69.6%
Video game console 301 7.2% 4,202 13.3% 4,568 12.6% 11,281 15.3%
OEM, royalty and licensing 824 19.8% 3,615 11.4% 3,642 10.0% 11,154 15.1%
North American, International and OEM, Royalty and Licensing Net Revenues
Overall, net revenues for the three months ended September 30, 2001
decreased 87 percent compared to the same period in 2000. This decrease resulted
from a 94 percent decrease in North American net revenues, a 74 percent decrease
in International net revenues and a 77 percent decrease in OEM, royalty and
licensing, as described below. The decrease in North American and International
net revenues for the three months ended September 30, 2001 was caused by not
releasing any new titles during the period compared to five titles in the same
period last year. Furthermore, we released Baldur's Gate II in the 2000 period,
which generated $14.0 million of revenue with no comparable release during the
2001 period. In addition, the volume of product returns and price concessions
granted to customers increased $2.2 million for the current three month period
as compared to the three months ended September 30, 2000 as we prepared for
transitioning our North American distribution to Vivendi Universal Interactive
Publishing ("Vivendi"). We expect that North American and International
publishing net revenues in 2001 will decrease compared to 2000 as certain titles
originally scheduled for release in the second half of 2001 have been
rescheduled for release in 2002. Furthermore, we have canceled or suspended
selected future titles, which we believe will not meet required forecasted
profit margins. The $2.8 million decrease in OEM, royalty and licensing net
revenues in the three months ended September 30, 2001 compared to the same
period in 2000 was due to decreased net revenues in the OEM business and in
licensing transactions primarily due to a decrease in the volume of transactions
which relates to the general market decrease in personal computer sales. We
expect that OEM, royalty and licensing net revenues for the year ended December
31, 2001 will decrease compared to the year ended December 31, 2000.
Net revenues for the nine months ended September 30, 2001 decreased 51
percent compared to the same nine month period in 2000. The decrease resulted
from a 40 percent decrease in North American net revenues, a 65 percent decrease
in International net revenues and a 67 percent decrease in OEM, royalty and
licensing. Overall, we released 19 fewer titles across multiple platforms this
year as compared to the same period last year. The decrease in North American
net revenues for the nine months ended September 30, 2001 was mainly because the
titles released during the period generated $15.2 million less sales volume as
well as higher product returns and price concessions compared to the same period
in 2000. The decrease in sales volume is attributable to the release of Baldur's
Gate II in the 2000 period and fewer titles released in the 2001 period. The
increase in product returns and price
17
concessions is due to the expected transition of our North American distribution
to Vivendi during the fourth quarter of 2001. In connection with this expected
transition, we granted certain price concessions on prior sales to minimize
future returns following the transition. International net revenues decreased
for the nine months ended September 30, 2001 mainly because the titles released
during the period generated $11.3 million less sales volume as well as higher
product returns and price concessions compared to the same period in 2000.
Furthermore, we released the English version of Baldur's Gate II in the 2000
period. The $7.5 million decrease in OEM, royalty and licensing net revenues in
the nine months ended September 30, 2001 compared to the same period in 2000 was
due to decreased net revenues in the OEM business and in licensing transactions.
The $3.9 million decrease in the OEM business was primarily due to a decrease in
the volume of transactions which relates to the general market decrease in
personal computer sales, and the decrease in licensing transactions is primarily
due to a $3.0 million multi-product licensing transaction with Titus in 2000
that did not recur in 2001.
Platform Net Revenues
PC net revenues decreased 87 percent during the three months ended
September 30, 2001 compared to the same period in 2000. The decrease in PC net
revenues was attributable to the release of zero titles during the three months
ended September 30, 2001 compared to four titles in the 2000 period. We also
experienced an increase in product returns and price concessions as we are
transitioning our North American distribution to Vivendi during the fourth
quarter of 2001. Furthermore, we released Baldur's Gate II in the 2000 period.
We expect our PC net revenues to decrease in 2001 due to our increased focus on
next generation console titles, the cancellation of one selected project and
rescheduling the release of certain titles from 2001 to 2002. We do not
anticipate releasing any new major PC titles during the remainder of 2001. Video
game console net revenues decreased 93 percent during the three months ended
September 30, 2001 compared to the same period in 2000, due to releasing zero
video game console titles compared to the same period last year, in which we
released one video game console title. In addition, sales of previously released
video game console titles were $3.2 million higher in the 2000 period. We expect
our video game console net revenues to increase in 2001 as a result of a
substantial increase in planned title releases for next generation game consoles
in 2001 compared to 2000. Our anticipated major video game console releases for
the remainder of the year include Baldur's Gate: Dark Alliance (PlayStation 2),
the next product from the successful Baldur's Gate franchise, and Giants
(PlayStation 2).
For the nine months ended September 30, 2001, PC net revenues decreased
45 percent compared to the same period in 2000. The decrease is mainly due to
releasing six titles in the 2001 period compared to 19 titles in the 2000
period. We released three major titles during the nine months ended September
30, 2001 versus four in the comparable 2000 period with two of the titles in
2001 being expansions to previously released games resulting in a lower average
selling price than a stand alone game. In addition, we released Baldur's Gate II
in the 2000 period. Furthermore, the decrease in net PC revenues resulted from
higher than anticipated price concessions as we are transitioning our North
American distribution to Vivendi in the fourth quarter of 2001. Video game
console net revenues decreased 60 percent in the nine months ended September 30,
2001 compared to the same period in 2000 due to only releasing one video game
console title in 2001 versus seven titles in 2000.
Cost of Goods Sold; Gross Profit Margin
Cost of goods sold decreased 29 percent in the three months ended
September 30, 2001 compared to the same period in 2000 due to a lower gross
revenues base offset by higher amortization of prepaid royalties on externally
developed products, including approximately $5.9 million in write-offs of
canceled development projects. The 147 percent decrease in gross profit margin
was due to product returns and price concessions increasing as a percentage of
gross revenues as we are transitioning our North American distribution to
Vivendi, no internally developed products released in the 2001 period versus two
titles in the 2000 period, licensing revenue decreasing by $0.3 million and $5.9
million in write-offs of canceled development projects. We expect our cost of
goods sold to decrease in 2001 as compared to 2000 due to an expected lower net
revenues base partially offset by a higher proportion of console titles
released. In addition, we expect our gross profit margin in 2001 to decrease as
compared to 2000 due to an increase in console title revenues, which typically
have a higher cost of goods than PC titles, and the write-offs of canceled
development projects during 2001.
Cost of goods sold decreased 10 percent in the nine months ended
September 30, 2001 compared to the same period in 2000, due to a lower gross
revenues base offset by higher amortization of prepaid royalties on externally
developed products and approximately $8.1 million in write-offs of canceled
development projects. The 91 percent decrease in gross profit margin was
primarily due to a $4.2 million increase in product returns and price
concessions as compared to the same period in 2000 and product returns and price
concessions increasing as a percentage of gross revenues caused by transitioning
our North American distribution to Vivendi during the fourth quarter of 2001. We
18
also only released one internally developed expansion title in the 2001 period
versus four internally developed stand alone titles in the 2000 period, which
possess higher profit margins. Finally, licensing revenue decreased by $3.4
million and write-offs increased by $8.1 million in connection with canceled
development projects.
We may incur additional write-offs of prepaid royalties for titles in
development if additional projects are cancelled in order to reduce future
expenditures and reduce the funding requirements of future operations.
Marketing and Sales
Marketing and sales expenses primarily consist of advertising and
retail marketing support, sales commissions, marketing and sales personnel,
customer support services and other related operating expenses. The 34 percent
decrease in marketing and sales expenses for the three months ended September
30, 2001 compared to the 2000 period is primarily attributable to a $1.6 million
decrease in worldwide advertising and retail marketing support expenditures and
$0.5 million decrease in personnel costs and operating expenses. The six percent
decrease in marketing and sales expenses for the nine months ended September 30,
2001 compared to the 2000 period is attributable primarily to a $0.8 million
decrease in marketing and sales expenses for worldwide advertising and retail
marketing support expenditures offset by a $0.3 million in overhead fees payable
to Virgin in 2001, in connection with the terms of the April 2001 settlement of
a dispute with Virgin and a $0.5 million decrease in personnel costs and
operating expenses. We expect our marketing and sales expenses to decrease in
2001 as compared to 2000, due to decreased advertising and retail marketing
support expenditures as a result of fewer title releases and lower personnel
costs as a result of reductions in headcount during the three months ended and
subsequent to September 30, 2001, offset by the overhead fees payable to Virgin
in 2001, in connection with the terms of the April 2001 settlement of a dispute
with Virgin.
General and Administrative
General and administrative expenses primarily consist of administrative
personnel expenses, facilities costs, professional fees, bad debt expenses and
other related operating expenses. General and administrative expenses for the
three months ended September 30, 2001 decreased one percent due to a $0.2
million decrease in personnel costs as a result of a headcount reduction during
the 2001 period. Although we are continuing our efforts to reduce North American
operating expenses including a reduction of headcount subsequent to September
30, 2001, we expect general and administrative expenses to increase slightly in
2001 as compared to 2000 as a result of already incurred additional
expenditures.
The 21 percent increase in general and administrative expenses for the
nine months ended September 30, 2001 compared to the same period in 2000 is
primarily attributable to the additional expenditures due to a $0.6 million
provision for the termination of a building lease in the United Kingdom, $0.1
million increase in the provision for bad debt, $0.5 million in legal,
accounting and investment banking fees and expenses incurred principally in
connection with the efforts of a proposed sale of the Company which has been
terminated and $0.2 million increase in personnel costs.
Product Development
Product development expenses, which primarily consist of personnel and
support costs, are charged to operations in the period incurred. The ten percent
decrease in product development expenses for the three months ended September
30, 2001 is primarily due to $0.6 million decrease in personnel costs
expenditures associated with resources dedicated to completing one major
internally developed title in the prior period, which did not recur in the
current period. We expect product development expenses to decrease in 2001
compared to 2000, due to canceled or suspended future projects in an effort to
reduce expenditures and a reduction in headcount subsequent to September 30,
2001.
The seven percent decrease in product development expenses for the nine
months ended September 30, 2001 compared to the same period in 2000 is due to
$1.2 million decrease in expenditures associated with resources dedicated to
completing four major internally developed titles in the prior period, which did
not recur in the current period.
Other Expense, net
19
Other expense consists primarily of interest expense on our lines of
credit and foreign currency exchange transaction losses. Other expense increased
65 percent in the three months ended September 30, 2001 compared to the same
period in 2000 due to a $0.5 million provision for the possible tax liabilities
as the result of the Internal Revenue Service examination, a $0.2 million
expense associated with foreign tax withholdings, $0.8 million penalty due to a
delay in the effectiveness of a registration statement in connection with the
private placement of 8,126,770 shares of Common Stock, offset by a $0.5 million
decrease in interest expense on lower total debt and a $0.3 million decrease in
losses associated with foreign currency exchanges. If the registration statement
for the Common Stock shares sold in a private placement in April 2001 is not
declared effective, we will continue to accrue a two percent penalty each month
that the registration statement is not declared effective and there is no limit
on the amount payable. Because this payment is cumulative, this obligation could
have a material adverse effect on our financial condition. Moreover, we may be
unable to pay the total penalties due to the investors in the private placement
of Common Stock.
The 24 percent increase for the nine months ended September 30, 2001
compared to the same period in 2000 was due to a $0.5 million provision for the
possible tax liabilities as the result of the Internal Revenue Service
examination, a $0.2 million expense associated with foreign tax withholdings, a
$0.4 million in loan fees paid to the former bank associated with the transition
of our line of credit to a new bank and a $1.0 million penalty due to a delay in
the effectiveness of a registration statement in connection with the private
placement of 8,126,770 shares of Common Stock, offset by a $1.0 million decrease
in interest expense on lower total debt and a $0.4 million decrease in losses
associated with foreign currency exchanges.
Liquidity and Capital Resources
We have funded our operations to date primarily through the use of
lines of credit, from royalty and distribution fee advances, through cash
generated by the private sale of securities, from proceeds of the initial public
offering and from results of operations. As of September 30, 2001 our principal
resources included cash of $2.2 million and restricted cash of $0.6 million.
In April 2001, we secured a new working capital line of credit from a
bank and repaid all amounts outstanding on our former line of credit and
supplemental line of credit. These lines of credit were terminated upon full
payment. Our new working capital line of credit bears interest at the bank's
prime rate, or, at our option, a portion of the outstanding balance bears
interest at LIBOR plus 2.5%, for a fixed short-term. At September 30, 2001,
borrowings under the new working capital line of credit bore interest at various
interest rates between 6.00 percent and 6.18 percent. Our new line of credit
provides for borrowings and letters of credit of up to $15.0 million based in
part upon qualifying receivables and inventory. Under the new line of credit the
Company is required to maintain a $2.0 million personal guarantee by the
Company's Chairman and Chief Executive Officer ("Chairman"). The new line of
credit has a term of three years, subject to review and renewal by the bank on
April 30 of each subsequent year. As of September 30, 2001, we are not in
compliance with certain of the covenants under the new line of credit, including
financial covenants pertaining to net worth and minimum earnings before
interest, taxes, depreciation and amortization and recent agreements with Titus
and Vivendi. On October 26, 2001, the bank notified us that the credit agreement
was being terminated, all amounts are currently due payable and we would no
longer be able to continue to draw on the credit facility to fund future
operations. The bank and us are currently negotiating a payment plan for the
outstanding amounts. Because we depend on this credit agreement to fund our
operations, the bank's termination of the credit agreement could cause material
harm to our business, including our inability to continue as a going concern.
In addition, in April 2001, we completed a private placement of
8,126,770 shares of Common Stock for $12.7 million, and received net proceeds of
approximately $11.9 million. The shares were issued at $1.5625 per share, and
included warrants to purchase one share of Common Stock for each share sold. The
warrants are exercisable at $1.75 per share, and the warrants can be exercised
immediately. The warrants expire in March 2006. The transaction provides for a
registration statement covering the shares sold or issuable upon exercise of
such warrants to be filed by April 16, 2001 and become effective by May 31,
2001. In the event that the agreed effective date of the registration statement
is not met, we are subject to a two percent penalty per month, payable in cash,
until the registration statement is effective. We did not meet the effective
date of the registration statement and we are incurring a monthly penalty of
$254,000, payable in cash, until the effectiveness of the registration. This
obligation will continue to accrue each month that the registration statement is
not declared effective and does not have a limit on the amount payable to these
investors. Because this payment is cumulative, this obligation could have a
material adverse effect on our financial condition. As of September 30, 2001,
the amount accrued was $1.0 million. Moreover, we may be unable to pay the total
penalty due to the investors.
20
In April 2001, the Chairman provided us with a $3.0 million loan,
payable in May 2002, with interest at 10 percent. In connection with this loan
to us and the $2.0 million guarantee he provided under the new line of credit
from a bank, the Chairman received warrants to purchase 500,000 shares of our
Common Stock at $1.75 per share and vested upon issuance, expiring in April
2004.
Our primary capital needs have historically been to fund working
capital requirements necessary to fund our net losses, our sales growth, the
development and introduction of products and related technologies and the
acquisition or lease of equipment and other assets used in the product
development process. Our operating activities provided cash of $1.8 million
during the nine months ended September 30, 2001, primarily attributable to
collections of accounts receivable and advances from distribution agreements,
substantially offset by the net loss for the year and payments of accrued
liabilities. Net cash used by financing activities of $0.6 million for the nine
months ended September 30, 2001, consisted primarily of repayments of our
previous line of credit and supplemental line of credit from Titus offset by the
proceeds from the private placement of 8,126,770 shares of our Common Stock, an
advance for the development of future titles on a next generation video game
console, borrowings under our new working capital line of credit and borrowings
under a loan payable to our Chairman. Cash used in investing activities of $1.7
million for the nine months ended September 30, 2001 consisted of normal capital
expenditures, primarily for office and computer equipment used in our
operations. We do not currently have any material commitments with respect to
any future capital expenditures.
To reduce our working capital needs, we have implemented various
measures including a reduction of personnel, a reduction of fixed overhead
commitments, cancelled or suspended development on future titles, which we
believe do not meet sufficient projected profit margins and have scaled back
certain marketing programs. We will continue to pursue various alternatives to
improve future operating results, including strategic alliances such as the
distribution agreement with Vivendi and further expense reductions, some of
which may have a long-term adverse impact on our ability to generate successful
future business activities.
Advances under our line of credit are no longer available and we
owe the bank approximately $2.7 million as of November 9, 2001. We have not
released sufficient product during the three month period ended September 30,
2001 to generate a profitable level of revenues, or sufficient accounts
receivable to maximize the use of our credit line. We also anticipate that
delays in product releases could continue in the short-term, and funds available
from ongoing operations are not sufficient to satisfy the projected working
capital and capital expenditures to continue operating in the normal course of
business. In addition, we are not in compliance with certain covenants required
under our credit line and on October 26, 2001, the bank notified us that the
credit agreement was being terminated, all outstanding amounts are currently due
and payable and we must comply with all requirements in the credit agreement
with respect to collateral, including, but not limited to, not disposing of
collateral except in ordinary course of business and not moving same from its
current locations except in strict accordance with the credit agreement and we
would no longer be able to continue to draw on the credit facility to fund
future operations. In furtherance of the bank's notification with respect to
collateral, the bank informed us that upon any transfer of inventory or other
collateral to Vivendi, the bank must be paid for the portion of the loan balance
that is secured by any inventory that is transferred. The bank and us are
currently negotiating the payment of the outstanding amounts.
We will continue to implement cost reduction programs, including a
reduction of personnel, a reduction of fixed overhead commitments, cancel or
suspend development on future titles and scale back certain marketing programs,
and continue to seek external sources of funding, including but not limited to,
a sale or merger of the Company, a private placement of the Company's capital
stock, the sale of selected assets, the licensing of certain product rights in
selected territories, selected distribution agreements, and/or other strategic
transactions sufficient to provide short-term funding, and potentially achieve
our long-term strategic objectives. However, there is no assurance that we can
complete the transactions necessary to provide the required funding on a timely
basis in order to continue operating as a going concern.
Our consolidated financial statements have been presented on the basis
that we are a going concern. However, our independent public accountant has
informed us that if we are unable to resolve the liquidity issues discussed
herein including paying off our line of credit with our current bank and
obtaining alternative debt or equity financing sufficient to cover our operating
cash flow requirements through December 31, 2001 and beyond, or to adequately
address the issues described above, that the report of independent public
accountants on our financial statements as of December 31, 2001 could contain a
going concern modification.
FACTORS AFFECTING FUTURE PERFORMANCE
Our future operating results depend upon many factors and are subject
to various risks and uncertainties. Some of the risks and uncertainties which
may cause our operating results to vary from anticipated results or which may
materially and adversely affect our operating results are as follows:
21
We currently have a number of obligations that we are unable to meet without
generating additional revenues or raising additional capital. If we cannot
generate additional revenues or raise additional capital in the near future, we
may become insolvent and our stock would become illiquid or worthless.
As of September 30, 2001, our cash balance was approximately $2.2
million and our outstanding accounts payable and current debt totaled
approximately $23.0 million. If we do not receive sufficient financing we may
(i) liquidate assets, (ii) seek or be forced into bankruptcy and/or (iii)
continue operations, but incur material harm to our business, operations or
financial condition. Additionally, because of our financial condition, our Board
of Directors has a duty to our creditors that may conflict with the interests of
our stockholders. When a Delaware corporation is operating in the vicinity of
insolvency, the Delaware courts have imposed upon the corporation's directors a
fiduciary duty to the corporation's creditors. If we cannot obtain additional
capital and become unable to pay our debts as they become due, our Board of
Directors may be required to make decisions that favor the interests of
creditors at the expense of our stockholders to fulfill its fiduciary duty. For
instance, we may be required to preserve our assets to maximize the repayment of
debts versus employing the assets to further grow our business and increase
shareholder value.
We depend, in part, on external financing to fund our capital needs. If we are
unable to obtain sufficient financing on favorable terms, we may not be able to
continue to operate our business.
Historically, our business has not generated revenues sufficient to
create operating profits. To supplement our revenues, we have funded our capital
requirements with debt and equity financing. Our ability to obtain additional
equity or debt financing depends on a number of factors including our financial
performance, the overall conditions in our industry, and our credit rating.
If we cannot raise additional capital on favorable terms, we will have
to reduce our costs by delaying, canceling, suspending or scaling back product
development and marketing programs. We may also be forced to sell or consolidate
operations. These measures could materially limit our ability to publish
successful titles and may not decrease our costs enough to permit us to operate
profitability, or at all.
Our stock price may decline significantly if we are delisted from the Nasdaq
National Market.
Our common stock currently is quoted on the Nasdaq National Market
System. For continued inclusion on the Nasdaq National Market, we must meet
certain tests, including a bid price of at least $1.00 and net tangible assets
of at least $4 million. Although Nasdaq has suspended the bid price requirement
until January 2, 2002, we would likely be subject to that requirement
thereafter. We currently are not in compliance with either the net tangible
assets requirement or the bid price requirement. Moreover, Nasdaq requires that
we maintain an Audit Committee of our Board of Directors, composed of at least
three independent directors. We currently do not meet the Audit Committee
requirement.
If we continue to fail to satisfy the listing standards on a continuous
basis, Nasdaq may delist our common stock from its National Market System. If
this occurs, trading of our common stock may be conducted on the Nasdaq SmallCap
Market, if we qualify for listing at that time, in the over-the-counter market
on the "pink sheets" or, if available, the NASD's "Electronic Bulletin Board."
In any of those cases, investors could find it more difficult to buy or sell, or
to obtain accurate quotations as to the value of our common stock. The trading
price per share of our common stock likely would be reduced as a result.
The variable conversion price of our Series A Preferred Stock increases our risk
of being delisted from the Nasdaq National Market.
The variable conversion price of our Series A Preferred Stock increases
our risk of being delisted from the Nasdaq National Market in several ways (see
"The variable conversion price of our Series A Preferred Stock could result in
the issuance of a significant number of shares of our common stock if our stock
price declines, which will have a dilutive impact on our stockholders"):
o The substantial number of shares that are potentially issuable
upon conversion of the Series A Preferred Stock and the short selling that may
occur as a result of the future priced nature of those shares increases the risk
that our stock price will stay below Nasdaq's minimum bid price requirement.
22
o If the returns on our Series A Preferred Stock are deemed
"excessive" compared with those of public investors in our common stock, Nasdaq
may deny inclusion or apply more stringent criteria to the continued listing of
our common stock.
o If Nasdaq determines that the past and prospective future
issuances of common stock upon conversion by Titus of its Series A Preferred
Stock constitutes a change in control of the Company or a change in its
financial structure, we would need to satisfy all initial listing requirements
as of that time, which currently we are unable to do.
A significant percentage of our revenues depend on our distributors' diligent
sales efforts and our distributors' and retail customers' timely payments to us.
Since February 1999, Virgin has been the exclusive distributor for most
of our products in Europe, the Commonwealth of Independent States, Africa and
the Middle East. Our agreement with Virgin expires in February 2006. In August
2001, we entered into a Distribution Agreement with Vivendi Universal
Interactive Publishing North America, or Vivendi, pursuant to which Vivendi will
distribute substantially all our products in North America commencing in October
2001. Our agreement with Vivendi expires in December 2003, but may be extended
with respect to certain named products.
Virgin and Vivendi each have exclusive rights to distribute our
products in substantial portions of the world. As a consequence, the
distribution of our products by Virgin and Vivendi will generate a substantial
majority of our revenues, and proceeds from Virgin and Vivendi from the
distribution of our products will constitute a substantial majority of our
operating cash flows. Therefore, our revenues and cash flows could fall
significantly and our business and financial results could suffer material harm
if:
o either Virgin or Vivendi fails to deliver to us the full
proceeds owed us from distribution of our products;
o either Virgin or Vivendi fails to effectively distribute our
products in their respective territories; or
o either Virgin or Vivendi otherwise fails to perform under the
distribution agreement.
We typically sell to distributors and retailers on unsecured credit,
with terms that vary depending upon the customer and the nature of the product.
We confront the risk of non-payment from our customers, whether due to their
financial inability to pay us, or otherwise. In addition, while we maintain a
reserve for uncollectible receivables, the reserve may not be sufficient in
every circumstance. As a result, a payment default by a significant customer
could cause material harm to our business.
The termination of our existing credit agreement has resulted in a substantial
reduction in the cash available to finance our operations.
Pursuant to our credit agreement with LaSalle Business Credit Inc., or
"LaSalle", entered into in April 2001, we agreed to certain covenants. We
currently are not in compliance with some of those covenants. In October 2001,
LaSalle notified us that the credit agreement was being terminated and we would
no longer be able to continue to draw on the credit facility to fund future
operations. We are currently negotiating with LaSalle the payment of the
outstanding balance under the credit agreement, which is currently due and
payable and is approximately $2.7 million on November 9, 2001. There can be no
assurance that our discussions with LaSalle will result in a forbearance of
amounts due. Because we depend on our credit agreement to fund our operations,
LaSalle's termination of the credit agreement has significantly impeded our
ability to fund our operations and has caused material harm to our business. We
will need to enter into a new credit facility to fund our operations. There can
be no assurance that we will be able to enter into a new credit agreement or
that if we do enter into a new credit agreement, it will be on terms favorable
to us.
The variable conversion price of our Series A Preferred Stock could result in
the issuance of a significant number of shares of our common stock if our stock
price declines, which will have a dilutive impact on our stockholders.
Titus Interactive S.A. may convert each share of its Series A Preferred
Stock into a number of shares of our common stock determined by dividing $27.80
by the lesser of (i) $2.78 or (ii) 85 percent of the average closing price per
share as reported by Nasdaq for the twenty trading days preceding the date of
conversion. Consequently, the
23
number of shares issuable to Titus upon conversion of its Series A Preferred
Stock increase as our stock price declines.
The table below sets forth the number of shares and the percentages of
our common stock that Titus would own if Titus elected to convert its remaining
383,354 shares of Series A Preferred Stock. The share amounts and the
percentages include, in addition to the shares of common stock Titus has the
right to acquire upon conversion of its remaining Series A Preferred Stock,
19,474,761 shares of common stock already owned by Titus and 460,298 shares of
common stock that Titus has the right to acquire upon exercise of warrants that
currently are exercisable. The share amounts and percentages do not include any
shares of common stock that Titus may elect to receive for accrued dividends on
the Series A Preferred Stock at the time of its conversion to common stock. The
share amounts and the percentages are based on the average closing price per
share of the Company's common stock for the 20 trading days immediately
preceding November 12, 2001, which was $0.61 per share, and on assumed average
prices of $0.458, $0.305 and $0.153, which prices represent a 25%, 50% and 75%
decline, respectively, in the November 12, 2001 average price. The percentages
are also based on 44,985,708 shares of our common stock outstanding on November
12, 2001.
Percentage Decline in Assumed Percentage of
October 29, 2001 Average Shares of Outstanding
Average Price Price Common Stock Common Stock
--------------------- ----------- --------------- -----------------
-- $0.61 40,489,044 61.35%
25% $0.46 47,340,372 64.98%
50% $0.31 61,043,029 70.53%
75% $0.15 101,882,319 79.97%
Titus Interactive SA controls a majority of our voting stock and can elect a
majority of our Board of Directors and prevent an acquisition of the Company
that is favorable to our other stockholders.
As of November 9, 2001, Titus owned approximately 52 percent of the
total voting power of our capital stock. If Titus converted its remaining Series
A Preferred Stock on November 9, 2001, Titus would own 61 percent of the total
voting power of our capital stock. As a consequence, Titus can control
substantially all matters requiring stockholder approval, including the election
of directors, subject to our stockholders' cumulative voting rights, and the
approval of mergers or other business combination transactions. Additionally,
pursuant to the terms of our Series A Preferred Stock, Titus also has the
ability to block approval of a merger or change in control that the other
holders of our common stock may deem beneficial. At our 2001 annual stockholders
meeting on September 18, 2001, Titus exercised its voting power to elect a
majority of our Board of Directors. Three of the 6 members of the Board
employees or directors of Titus, and Titus' Chief Executive Officer serves as
our President.
Our long-term exclusive distribution agreement with Virgin Interactive
Entertainment Limited may discourage potential acquirors from acquiring us.
Pursuant to the settlement agreement we entered into with Titus, Virgin
Interactive Entertainment Limited, or Virgin, and their affiliate on April 11,
2001, during the seven-year term of our February 1999 distribution agreement
with Virgin, we agreed not to sell, license our publishing rights, or enter into
any agreement to either sell or license our publishing rights with respect to
any products covered by the distribution agreement in the territory covered by
the distribution agreement, with the exception of two qualified sales each year.
The restrictions on sales and licensing of publishing rights until 2006 may
discourage potential acquirors from entering into an acquisition transaction
with us, or may cause potential acquirors to demand terms that are less
favorable to our stockholders.
In addition, we cannot terminate the distribution agreement without
incurring penalties of a minimum of $10 million, subject to substantial
increases pursuant to the terms of the distribution agreement, which also may
discourage potential acquirors that already have their own distribution
capabilities in territories covered by the distribution agreement.
A change of control may cause the termination of some of our material contracts
with our licensors and distributors.
Some of our license, development and distribution agreements contain
provisions that allow the other party to terminate the agreement upon a change
in control of the Company. Titus recently converted a portion of their
24
preferred stock into common stock, which as of November 9, 2001 gave Titus 52%
of our total voting power. At our 2001 annual stockholders meeting on September
18, 2001, Titus exercised its voting power to elect a majority of our Board of
Directors. Some of our third-party developers and licensors may assert that
these events constitute a change in control of the Company and attempt to
terminate their respective agreements with us. In particular, our license for
"the Matrix" allows for the licensor to terminate the license if there is a
substantial change of ownership or control without their approval. The loss of
the Matrix license would materially harm our projected operating results and
financial condition.
The unpredictability of our quarterly results may cause our stock price to
decline.
Our operating results have fluctuated in the past and may fluctuate in
the future due to several factors, some of which are beyond our control. These
factors include:
o demand for our products and our competitors' products;
o the size and rate of growth of the market for interactive
entertainment software;
o changes in personal computer and video game console platforms;
o the timing of announcements of new products by us and our
competitors and the number of new products and product
enhancements released by us and our competitors;
o changes in our product mix;
o the number of our products that are returned; and
o the level of our international and original equipment
manufacturer royalty and licensing net revenues.
Many factors make it difficult to accurately predict the quarter in
which we will ship our products. Some of these factors include:
o the uncertainties associated with the interactive
entertainment software development process;
o approvals required from content and technology licensors; and
o the timing of the release and market penetration of new game
hardware platforms.
It is likely that in some future periods our operating results will not
meet the expectations of the public or of public market analysts. Any
unanticipated change in revenues or operating results is likely to cause our
stock price to fluctuate since such changes reflect new information available to
investors and analysts. New information may cause securities analysts and
investors to revalue our stock and this may cause fluctuations in our stock
price.
There are high fixed costs to developing our products. If our revenues decline
because of delays in the introduction of our products, or if there are
significant defects or dissatisfaction with our products, our business could be
harmed.
25
We have incurred significant net losses in recent periods, including a
net loss of $41.4 million in the nine months ended September 30, 2001, $12.1
million during 2000 and $41.7 million during 1999. Our losses stem partly from
the significant costs we incur to develop our entertainment software products.
Moreover, a significant portion of our operating expenses are relatively fixed,
with planned expenditures based largely on sales forecasts. At the same time,
most of our products have a relatively short life cycle and sell for a limited
period of time after their initial release, usually less than one year.
Relatively fixed costs and short windows in which to earn revenues mean
that sales of new products are important in enabling us to recover our
development costs, to fund operations and to replace declining net revenues from
older products. Our failure to accurately assess the commercial success of our
new products, and our delays in releasing new products, could reduce our net
revenues and our ability to recoup development and operational costs.
Our growing dependence on revenues from game console software products increases
our exposure to seasonal fluctuations in the purchases of game consoles.
The interactive entertainment software industry is highly seasonal,
with the highest levels of consumer demand occurring during the year-end holiday
buying season. As a result, our net revenues, gross profits and operating income
have historically been highest during the second half of the year. The impact of
this seasonality will increase as we rely more heavily on game console net
revenues in the future. Moreover, delays in game console software products
largely depend on the timeliness of introduction of game console platforms by
the manufacturers of those platforms, such as Microsoft and Nintendo. The
introduction by a manufacturer of a new game platform too late in the holiday
buying season could result in a substantial loss of revenues by us. Seasonal
fluctuations in revenues from game console products may cause material harm to
our business and financial results.
If our products do not achieve broad market acceptance, our business could be
harmed significantly.
Consumer preferences for interactive entertainment software are always
changing and are extremely difficult to predict. Historically, few interactive
entertainment software products have achieved continued market acceptance.
Instead, a limited number of releases have become "hits" and have accounted for
a substantial portion of revenues in our industry. Further, publishers with a
history of producing hit titles have enjoyed a significant marketing advantage
because of their heightened brand recognition and consumer loyalty. We expect
the importance of introducing hit titles to increase in the future. We cannot
assure you that our new products will achieve significant market acceptance, or
that we will be able to sustain this acceptance for a significant length of time
if we achieve it.
We believe that our future revenue will continue to depend on the
successful production of hit titles on a continuous basis. Because we introduce
a relatively limited number of new products in a given period, the failure of
one or more of these products to achieve market acceptance could cause material
harm to our business. Further, if our products do not achieve market acceptance,
we could be forced to accept substantial product returns or grant significant
pricing concessions to maintain our relationship with retailers and our access
to distribution channels. If we are forced to accept significant product returns
or grant significant pricing concessions, our business and financial results
could suffer material harm.
Our reliance on third party software developers subjects us to the risks that
these developers will not supply us in a timely manner with high quality
products or on acceptable terms.
Third party interactive entertainment software developers, such as
Bioware Corp. and Planet Moon Studios develop many of our software products.
Since we depend on these developers in the aggregate, we remain subject to the
following risks:
o limited financial resources may force developers out of
business prior to their completion of projects for us or
require us to fund additional costs; and
o the possibility that developers could demand that we
renegotiate our arrangements with them to include new terms
less favorable to us.
Increased competition for skilled third party software developers also
has compelled us to agree to make advance payments on royalties and to guarantee
minimum royalty payments to intellectual property licensors and game developers.
Moreover, if the products subject to these arrangements, are not delivered
timely, or with acceptable quality, or do not generate sufficient sales volumes
to recover these royalty advances and guaranteed
26
payments, we would have to write-off unrecovered portions of these payments,
which could cause material harm to our business and financial results.
If we fail to anticipate changes in video game platforms and technology, our
business may be harmed.
The interactive entertainment software industry is subject to rapid
technological change. New technologies could render our current products or
products in development obsolete or unmarketable. Some of these new technologies
include:
o operating systems such as Microsoft Windows 2000;
o technologies that support games with multi-player and online
features;
o new media formats such as online delivery and digital video
disks, or DVDs; and
o recent releases or planned releases in the near future of new
video game consoles such as the Sony Playstation 2, the
Nintendo Gamecube and the Microsoft Xbox.
We must continually anticipate and assess the emergence of, and market
acceptance of, new interactive entertainment software platforms well in advance
of the time the platform is introduced to consumers. Because product development
cycles are difficult to predict, we must make substantial product development
and other investments in a particular platform well in advance of introduction
of the platform. If the platforms for which we develop new software products or
modify existing products are not released on a timely basis or do not attain
significant market penetration, or if we develop products for a delayed or
unsuccessful platform, our business and financial results could suffer material
harm.
New interactive entertainment software platforms and technologies also
may undermine demand for products based on older technologies. Our success will
depend in part on our ability to adapt our products to those emerging game
platforms that gain widespread consumer acceptance. Our business and financial
results may suffer material harm if we fail to:
o anticipate future technologies and platforms and the rate of
market penetration of those technologies and platforms;
o obtain licenses to develop products for those platforms on
favorable terms; or
o create software for those new platforms on a timely basis.
We compete with a number of companies that have substantially greater financial,
marketing and product development resources than we do.
The interactive entertainment software industry is intensely
competitive and new interactive entertainment software programs and platforms
are regularly introduced. The greater resources of our competitors permit them
to undertake more extensive marketing campaigns, adopt more aggressive pricing
policies, and pay higher fees than we can to licensors of desirable motion
picture, television, sports and character properties and to third party software
developers.
We compete primarily with other publishers of personal computer and
video game console interactive entertainment software. Significant competitors
include Electronic Arts Inc., Activision, Inc., and Vivendi Universal
Interactive Publishing.
Many of these competitors have substantially greater financial,
technical and marketing resources, larger customer bases, longer operating
histories, greater name recognition and more established relationships in the
industry than we do. Competitors with more extensive customer bases, broader
customer relationships and broader industry alliances may be able to use such
resources to their advantage in competitive situations, including establishing
relationships with many of our current and potential customers.
27
In addition, integrated video game console hardware/software companies
such as Sony Computer Entertainment, Nintendo, and Microsoft Corporation compete
directly with us in the development of software titles for their respective
platforms and they have generally discretionary approval authority over the
products we develop for their platforms. Large diversified entertainment
companies, such as The Walt Disney Company, many of which own substantial
libraries of available content and have substantially greater financial
resources, may decide to compete directly with us or to enter into exclusive
relationships with our competitors. We also believe that the overall growth in
the use of the Internet and online services by consumers may pose a competitive
threat if customers and potential customers spend less of their available home
personal computing time using interactive entertainment software and more time
using the Internet and online services.
We may face difficulty obtaining access to retailers necessary to market and
sell our products effectively.
Retailers typically have a limited amount of shelf space and
promotional resources, and there is intense competition among consumer software
producers, and in particular producers of interactive entertainment software
products, for high quality retail shelf space and promotional support from
retailers. To the extent that the number of consumer software products and
computer platforms increases, competition for shelf space may intensify and
require us to increase our marketing expenditures. Due to increased competition
for limited shelf space, retailers and distributors are in an improving position
to negotiate favorable terms of sale, including price discounts, price
protection, marketing and display fees and product return policies. Our products
constitute a relatively small percentage of any retailer's sales volume, and we
cannot assure you that retailers will continue to purchase our products or to
provide our products with adequate levels of shelf space and promotional
support. A prolonged failure in this regard may cause material harm to our
business.
Because we sell a substantial portion of our products on a purchase order basis,
our sales may decline substantially without warning and in a brief period of
time.
We currently sell our products through our sales force to mass
merchants, warehouse club stores, large computer and software specialty chains
and through catalogs in the United States and Canada, as well as to certain
distributors. Outside North America, we generally sell products to third party
distributors. We make our sales primarily on a purchase order basis, without
long-term agreements. The loss of, or significant reduction in sales to, any of
our principal retail customers or distributors could cause material harm to our
business.
Our customers have the ability to return our products or to receive pricing
concessions and such returns and concessions could reduce our net revenues and
results of operations.
We are exposed to the risk of product returns and pricing concessions
with respect to our distributors and retailers. We allow distributors and
retailers to return defective, shelf-worn and damaged products in accordance
with negotiated terms, and also offer a 90-day limited warranty to our end users
that our products will be free from manufacturing defects. In addition, we
provide pricing concessions to our customers to manage our customers' inventory
levels in the distribution channel. We could be forced to accept substantial
product returns and provide pricing concessions to maintain our relationships
with retailers and our access to distribution channels. Product return and
pricing concessions that exceed our reserves have caused material harm to our
results of operations in the recent past and may do so again in the future.
Substantial sales of our common stock by our existing stockholders may reduce
the price of our stock and dilute existing stockholders.
We have filed registration statements covering a total of approximately
49.5 million shares of our common stock for the benefit of the holders we
describe below. Assuming the effectiveness of these registration statements,
these shares would be eligible for immediate resale in the public market.
o Universal Studios, Inc. (now owned by Vivendi) holds
approximately 10.4%, of our outstanding common stock, all of
which are being registered pursuant to registration statement
number 333-59088, filed on April 17, 2001.
o Titus currently holds approximately 43.3% of our outstanding
common stock and, if Titus converted all of its shares of
Series A Preferred Stock on November 9, 2001, would own
approximately 61.1% of our common stock. All of the shares of
common stock issuable to Titus upon the conversion of the
preferred stock, and
28
common stock issuable to Titus upon exercise of warrants, are
being registered in our pending registration statements.
o Pursuant to registration statement 333-59088, filed on April
17, 2001, we intend to register shares equal to approximately
38% of our currently outstanding common stock, held by a
number of our investors as set forth in that registration
statement.
o Employees and directors hold options and warrants to purchase
10.8% of our common stock, most of which are eligible for
immediate resale. We may issue options to purchase up to an
additional 2.2% of our common stock to employees and
directors, which we anticipate will be freely tradable when
issued.
Although the holders described above are subject to restrictions on the
transfer of our common stock, future sales by such holders could decrease the
trading price of our common stock and, therefore, the price at which you could
resell your shares. A lower market price for our shares also might impair our
ability to raise additional capital through the sale of our equity securities.
Any future sales of our stock would also dilute existing stockholders.
We depend upon third party licenses of content for many of our products.
Many of our current and planned products, such as our Star Trek,
Advanced Dungeons and Dragons, Matrix and Caesars Palace titles, are lines based
on original ideas or intellectual properties licensed from other parties. From
time to time we may not be in compliance with certain terms of these license
agreements, and our ability to market products based on these licenses may be
negatively impacted. Moreover, disputes regarding these license agreements may
also negatively impact our ability to market products based on these licenses.
For instance, we are in discussion with Infogrames about our failure to make
scheduled royalty payments. If these discussions are not successful, Infogrames
may terminate our agreement which would significantly impact our ability to
market many of our most successful products. Additionally, we may not be able to
obtain new licenses, or maintain or renew existing licenses, on commercially
reasonable terms, if at all. For example, Viacom Consumer Products, Inc. has
granted the Star Trek license to another party upon the expiration of our rights
in 2002. If we are unable to maintain current licenses or obtain new licenses
for the underlying content that we believe offers the greatest consumer appeal,
we would either have to seek alternative, potentially less appealing licenses,
or release products without the desired underlying content, either of which
could limit our commercial success and cause material harm to our business .
We may fail to maintain existing licenses, or obtain new licenses from hardware
companies on acceptable terms or to obtain renewals of existing or future
licenses from licensors.
We are required to obtain a license to develop and distribute software
for each of the video game console platforms for which we develop products,
including a separate license for each of North America, Japan and Europe. We
have obtained licenses to develop software for the Sony PlayStation and
PlayStation 2, as well as video game platforms from Nintendo and Microsoft. In
addition, each of these companies has the right to approve the technical
functionality and content of our products for their platforms prior to
distribution. Due to the competitive nature of the approval process, we must
make significant product development expenditures on a particular product prior
to the time we seek these approvals. Our inability to obtain these approvals
could cause material harm to our business.
Our sales volume and the success of our products depends in part upon
the number of product titles distributed by hardware companies for use with
their video game platforms.
Even after we have obtained licenses to develop and distribute
software, we depend upon hardware companies such as Sony Computer Entertainment,
Nintendo and Microsoft, or their designated licensees, to manufacture the CD-ROM
or DVD-ROM media discs that contain our software. These discs are then run on
the companies' video game consoles. This process subjects us to the following
risks:
o we are required to submit and pay for minimum numbers of discs
we want produced containing our software, regardless of
whether these discs are sold, shifting onto us the financial
risk associated with poor sales of the software developed by
us; and
o reorders of discs are expensive, reducing the gross margin we
receive from software releases that have stronger sales than
initially anticipated and that require the production of
additional discs.
As a result, video game console hardware licensors can shift onto us
the risk that if actual retailer and consumer demand for our interactive
entertainment software differs from our forecasts, we must either the bear the
loss from
29
overproduction or the lesser per-unit revenues associated with producing
additional discs. Either situation could lead to material reductions in our net
revenues.
If we fail to maintain any of our current licenses for console
hardware, we will be unable to publish products for that console. Moreover, if
we fail to maintain our license for the Microsoft Xbox, Microsoft could require
us to repay an advance from them. Our agreements with Microsoft ancillary to our
Xbox license require, among other things, that we continue development of our
Matrix product, and that we maintain our credit agreement with LaSalle.
Microsoft may consider the potential for termination of our Matrix license and
our current non-compliances with the LaSalle credit agreement to be of
sufficient materiality to require repayment of the advance. (See "A change of
control may cause the termination of some of our material contracts with our
licensors and distributors" and "Our failure to comply with the covenants in our
existing credit agreement could result in the termination of the agreement and a
substantial reduction in the cash available to finance our operations.") Our
failure to maintain any console hardware license, or any requirement by
Microsoft that we repay the advance to them, could cause material harm to our
business.
We have a limited number of key personnel. The loss of any single key person or
the failure to hire and integrate capable new key personnel could harm our
business.
Our interactive entertainment software requires extensive time and
creative effort to produce and market. The production of this software is
closely tied to the continued service of our key product design, development,
sales, marketing and management personnel. Our future success also will depend
upon our ability to attract, motivate and retain qualified employees and
contractors, particularly software design and development personnel. Competition
for highly skilled employees is intense, and we may fail to attract and retain
such personnel. Alternatively, we may incur increased costs in order to attract
and retain skilled employees. Our failure to retain the services of key
personnel, including competent executive management, or to attract and retain
additional qualified employees could cause material harm to our business.
Our international sales expose us to risks of unstable foreign economies,
difficulties in collection of revenues, increased costs of administering
international business transactions and fluctuations in exchange rates.
Our net revenues from international sales accounted for approximately
20 percent of our total net revenues for the nine months ended September 30,
2001 and approximately 28 percent for the nine months ended September 30, 2000.
Most of these revenues come from our distribution relationship with Virgin,
pursuant to which Virgin became the exclusive distributor for most of our
products in Europe, the Commonwealth of Independent States, Africa and the
Middle East. To the extent our resources allow, we intend to continue to expand
our direct and indirect sales, marketing and product localization activities
worldwide.
Our international sales and operations are subject to a number of
inherent risks, including the following:
o recessions in foreign economies may reduce purchases of our
products;
o translating and localizing products for international markets
is time- consuming and expensive;
o accounts receivable are more difficult to collect and when
they are collectible, they may take longer to collect;
o regulatory requirements may change unexpectedly;
o it is difficult and costly to staff and manage foreign
operations;
o fluctuations in foreign currency exchange rates;
o political and economic instability;
o our dependence on Virgin as our exclusive distributor in
Europe, the Commonwealth of Independent States, Africa and the
Middle East; and
o delays in market penetration of new platforms in foreign
territories.
30
These factors may cause material declines in our future international
net revenues and, consequently, could cause material harm to our business.
A significant, continuing risk we face from our international sales and
operations stems from exchange rate fluctuations. Because we do not engage in
currency hedging activities, fluctuations in currency exchange rates have caused
significant reductions in our net revenues from international sales and
licensing due to the loss in value upon conversion into U.S. Dollars. We may
suffer similar losses in the future.
Inadequate intellectual property protections could prevent us from enforcing or
defending our proprietary technology.
We regard our software as proprietary and rely on a combination of
patent, copyright, trademark and trade secret laws, employee and third party
nondisclosure agreements and other methods to protect our proprietary rights. We
own or license various copyrights and trademarks, and hold the rights to one
patent application related to one of our titles. While we provide "shrinkwrap"
license agreements or limitations on use with our software, it is uncertain to
what extent these agreements and limitations are enforceable. We are aware that
some unauthorized copying occurs within the computer software industry, and if a
significantly greater amount of unauthorized copying of our interactive
entertainment software products were to occur, it could cause material harm to
our business and financial results.
Policing unauthorized use of our products is difficult, and software
piracy can be a persistent problem, especially in some international markets.
Further, the laws of some countries where our products are or may be distributed
either do not protect our products and intellectual property rights to the same
extent as the laws of the United States, or are weakly enforced. Legal
protection of our rights may be ineffective in such countries, and as we
leverage our software products using emerging technologies such as the Internet
and online services, our ability to protect our intellectual property rights and
to avoid infringing others' intellectual property rights may diminish. We cannot
assure you that existing intellectual property laws will provide adequate
protection for our products in connection with these emerging technologies.
We may unintentionally infringe on the intellectual property rights of others,
which could expose us to substantial damages or restrict our operations.
As the number of interactive entertainment software products increases
and the features and content of these products continue to overlap, software
developers increasingly may become subject to infringement claims. Although we
believe that we make reasonable efforts to ensure that our products do not
violate the intellectual property rights of others, it is possible that third
parties still may claim infringement. From time to time, we receive
communications from third parties regarding such claims. Existing or future
infringement claims against us, whether valid or not, may be time consuming and
expensive to defend. Intellectual property litigation or claims could force us
to do one or more of the following:
o cease selling, incorporating or using products or services
that incorporate the challenged intellectual property;
o obtain a license from the holder of the infringed intellectual
property, which license, if available at all, may not be
available on commercially favorable terms; or
o redesign our interactive entertainment software products,
possibly in a manner that reduces their commercial appeal.
Any of these actions may cause material harm to our business and
financial results.
Our software may be subject to governmental restrictions or rating systems.
Legislation is periodically introduced at the state and federal levels
in the United States and in foreign countries to establish a system for
providing consumers with information about graphic violence and sexually
explicit material contained in interactive entertainment software products. In
addition, many foreign countries have laws that permit governmental entities to
censor the content of interactive entertainment software. We believe that
mandatory government-run rating systems eventually will be adopted in many
countries that are significant markets or potential
31
markets for our products. We may be required to modify our products to comply
with new regulations, which could delay the release of our products in those
countries.
Due to the uncertainties regarding such rating systems, confusion in
the marketplace may occur, and we are unable to predict what effect, if any,
such rating systems would have on our business. In addition to such regulations,
certain retailers have in the past declined to stock some of our products
because they believed that the content of the packaging artwork or the products
would be offensive to the retailer's customer base. While to date these actions
have not caused material harm to our business, we cannot assure you that similar
actions by our distributors or retailers in the future would not cause material
harm to our business.
Our directors and officers control a large percentage of our voting stock and
may use this control to compel corporate actions that are not in the best
interests of our stockholders as a whole.
Including Titus, our directors and executive officers beneficially own
approximately 58 percent of our aggregate common stock. In the event Titus
converts all of its shares of Series A Preferred Stock into common stock, the
additional shares could increase Titus' ownership to approximately 66 percent.
These stockholders can control substantially all matters requiring stockholder
approval, including the election of directors, subject to our stockholders'
cumulative voting rights, and the approval of mergers or other business
combination transactions. This concentration of voting power could discourage or
prevent a change in control that otherwise could result in a premium in the
price of our common stock.
We may fail to implement Internet-based product offerings successfully.
We seek to establish an online presence by creating and supporting
sites on the Internet and by offering our products through these sites. Our
ability to establish an online presence and to offer online products
successfully depends on:
o increases in the Internet's data transmission capability;
o growth in an online market sizeable enough to make commercial
transactions profitable.
Because global commerce and the exchange of information on the Internet
and other open networks are relatively new and evolving, a viable commercial
marketplace on the Internet may not emerge and complementary products for
providing and carrying Internet traffic and commerce may not be developed. Even
with the proper infrastructure, we may fail to develop a profitable online
presence or to generate any significant revenue from online product offerings in
the near future, or at all.
If the Internet does not become a viable commercial marketplace, or if
this development occurs but is insufficient to meet our needs or if such
development is delayed beyond the point where we plan to have established an
online service, our business and financial condition could suffer material harm.
Some provisions of our charter documents may make takeover attempts difficult,
which could depress the price of our stock and inhibit our ability to receive a
premium price for your shares.
Our Board of Directors has the authority, without any action by the
stockholders, to issue up to 4,616,646 shares of preferred stock and to fix the
rights and preferences of such shares. In addition, our certificate of
incorporation and bylaws contain provisions that:
o eliminate the ability of stockholders to act by written
consent and to call a special meeting of stockholders; and
o require stockholders to give advance notice if they wish to
nominate directors or submit proposals for stockholder
approval.
These provisions may have the effect of delaying, deferring or
preventing a change in control, may discourage bids for our common stock at a
premium over its market price and may adversely affect the market price, and the
voting and other rights of the holders, of our common stock.
32
Our stock price is volatile.
The trading price of our common stock has previously fluctuated and
could continue to fluctuate in response to factors that are largely beyond our
control, and which may not be directly related to the actual operating
performance of our business, including:
o general conditions in the computer, software, entertainment,
media or electronics industries;
o changes in earnings estimates or buy/sell recommendations by
analysts;
o investor perceptions and expectations regarding our products,
plans and strategic position and those of our competitors and
customers; and
o price and trading volume volatility of the broader public
markets, particularly the high technology sections of the
market.
We do not pay dividends on our common stock.
We have not paid any cash dividends on our common stock and do not
anticipate paying dividends in the foreseeable future.
Increases in interest rates will increase the cost of our debt.
Our working capital line of credit bears interest at either the bank's
prime rate or LIBOR, at our option, both of which are variable rates. As such,
if interest rates increase, we will have to use more cash to service our debt,
which could impede our ability to meet other expenses as they become due and
could cause material harm to our business and financial condition.
33
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not have any derivative financial instruments as of September 30,
2001. However, we are exposed to certain market risks arising from transactions
in the normal course of business, principally the risk associated with interest
rate fluctuations on our revolving line of credit agreement, and the risk
associated with foreign currency fluctuations. We do not hedge our interest rate
risk, or our risk associated with foreign currency fluctuations.
Interest Rate Risk
The table below provides information as of September 30, 2001 about our
other financial instruments that are sensitive to changes in interest rates.
Working Capital Line of Credit (Variable Rate)
----------------------------------------------
Amount borrowed at September 30, 2001 $4.9 million
Maximum amount of Line $15.0 million (1)
Variable interest rates 6.00 - 6.18% (2)
Expiration April 30, 2004 (3)
(1) Advances under the line are limited to an advance formula of
qualified accounts receivable and inventory.
(2) Borrowings bear interest at the bank's prime rate, or, at our
option, a portion of the outstanding balance at LIBOR plus 2.5
percent. As a result of the line being terminated subsequent
to September 30, 2001, the interest rate will increase two
percent above the original interest rate.
(3) The line is subject to review and renewal by the bank on April
30, 2002 and 2003. At September 30, 2001, we were not in
compliance with certain financial covenants and the line
has been terminated and an acceleration of payment has been
requested.
Foreign Currency Risk
Our earnings are affected by fluctuations in the value of our foreign
subsidiary's functional currency, and by fluctuations in the value of the
functional currency of our foreign receivables, primarily from Virgin. We
recognized foreign exchange losses of $51,000 for the nine months ended
September 30, 2001 and $935,000 for the year ended December 31, 2000, primarily
in connection with foreign exchange fluctuations in the timing of payments
received on accounts receivable from Virgin. Based upon the average foreign
currency rates for the nine months ended September 30, 2001, a hypothetical 10
percent change in the applicable foreign exchange rates would have increased our
loss by approximately $5,000.
34
PART II- OTHER INFORMATION
Item 1. Legal Proceedings
The Company is involved in various legal proceedings, claims
and litigation arising in the ordinary course of business, including
disputes arising over the ownership of intellectual property rights and
collection matters. In the opinion of management, the outcome of known
routine claims will not have a material adverse effect on the Company's
business, financial condition or results of operations.
Item 3. Defaults Upon Senior Securities
The Company is in default of certain covenants in its working
capital line of credit with LaSalle Business Credit Inc. ("LaSalle")
entered into in April 2001. These covenants include the financial
covenants related to net worth and minimum earnings before interest,
taxes, depreciation and amortization as of September 30, 2001, as well
as covenants prohibiting us from entering into transactions out of the
ordinary course of our business. Moreover, LaSalle retains the right to
terminate the credit agreement upon a change of control of the Company,
an event that may have occurred. In October 2001, LaSalle notified the
Company that the credit agreement was being terminated and that the
Company would no longer be able to continue to draw on the credit
facility to fund future operations. As of the date of this report,
LaSalle has not demanded payment of amounts due under the credit
agreement, and the Company continues to make payments to LaSalle in
accordance with the terms of the agreement. As of November 9, 2001,
amounts due under the credit agreement totaled approximately $2.7
million.
Item 4. Submission of Matters to a Vote of Security Holders
On September 18, 2001, the Company held its annual
stockholders' meeting. There were 44,980,708 shares of Common Stock
outstanding entitled to vote and a total of 22,573,358 shares (50.18
percent) were represented at the meeting in person or by proxy. In
addition, the 383,354 shares of Series A Preferred Stock owned by Titus
were represented and were entitled to 7,619,063 votes. The following
summarizes vote results of proposals submitted to the Company's
stockholders.
1. Proposal to elect directors, each for a term extending until the
next annual meeting of Stockholders or until their successors are
duly elected and qualified.
For Withheld
--------------------------------------------------------------
Brian Fargo 29,734,917 457,434
--------------------------------------------------------------
Herve Caen 29,668,322 524,083
--------------------------------------------------------------
Eric Caen 29,668,322 524,083
--------------------------------------------------------------
Nathan Peck 30,157,412 34,993
--------------------------------------------------------------
Michel Henri Vulpillat 30,093,605 98,800
--------------------------------------------------------------
Michel Welter 30,093,412 98,993
--------------------------------------------------------------
2. Proposal to ratify the appointment of Arthur Andersen LLP as
independent auditors for the fiscal year ending December 31, 2001.
For Against Abstain
-------------------------------------------------------------
30,160,255 150 32,000
-------------------------------------------------------------
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits - The following exhibits are filed as part of this report:
Exhibit
-------
Number Exhibit Title
------ -------------
10.1 Distribution Agreement between the Company and Vivendi
Universal Interactive Publishing North America, dated August
23, 2001. (Portions omitted pursuant to a request for
confidential treatment).
10.2 Amendment to the Distribution Agreement between the Company
and Vivendi Universal Interactive Publishing North America,
dated September 14, 2001 (Portions omitted pursuant to a
request for confidential treatment).
(b) Reports on Form 8-K
-------------------
The Company filed a Current Report on Form 8-K, dated September 21, 2001,
reporting that it had entered into a support agreement with its largest
stockholder, Titus Interactive, S.A. ("Titus"), to nominate a slate of
individuals for election as directors at the Company's annual meeting of
stockholders held September 18, 2001. As part of the Support Agreement, three of
the Company's existing directors resigned, and three new directors nominated by
Titus were appointed by the remaining directors to fill the three vacancies. The
new Board of Directors consists of five individuals nominated by Titus, and two
directors previously nominated by management who will continue to serve until
the annual meeting. In addition to agreeing to the change in composition of the
Board of Directors, the Company also agreed to retain Europlay 1, LLC as its
exclusive advisor to effect a restructuring of Interplay, with compensation to
be determined at a level at least equal to the compensation paid to industry
leading advisory firms for similar services.
35
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
INTERPLAY ENTERTAINMENT CORP.
Date: November 13, 2001 By: /s/ HERVE CAEN
--------------------------------------
Herve Caen,
President
(Principal Executive Officer)
Date: November 13, 2001 By: /s/ JEFF GONZALEZ
--------------------------------------
Jeff Gonzalez,
Vice President of Finance
(Principal Financial and Accounting
Officer)
36