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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended March 31, 1999 Commission File No. 0-27338
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GT INTERACTIVE SOFTWARE CORP.
(Exact name of registrant as specified in its charter)
DELAWARE 13-3689915
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification No.)
417 FIFTH AVENUE, NEW YORK, NY 10016
(Address of principal executive
offices) (Zip code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (212) 726-6500
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SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Common Stock, $0.01 par value
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No_____
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
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The aggregate market value of the registrant's Common Stock, held by
non-affiliates of the registrant, based on the closing sale price of the Common
Stock on June 18, 1999 as reported on the Nasdaq National Market, was
$109,189,723. As of June 18, 1999, there were 72,900,776 shares of the
registrant's Common Stock outstanding.
Portions of the registrant's definitive proxy statement ("Proxy Statement")
for the 1999 Annual Meeting of Stockholders are incorporated by reference into
Part III hereof.
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GT INTERACTIVE SOFTWARE CORP.
MARCH 31, 1999 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I
Item 1. Business.................................................... 2
Item 2. Properties.................................................. 16
Item 3. Legal Proceedings........................................... 16
Item 4. Submission of Matters to a Vote of Security Holders......... 18
PART II
Item 5. Market for the Registrant's Common Equity and Related 19
Stockholder Matters.........................................
Item 6. Selected Financial Data..................................... 20
Item 7. Management's Discussion and Analysis of Financial Condition 22
and Results of Operations...................................
Item 8. Index to the Financial Statements and Supplementary Data.... 34
Item 9. Changes in and Disagreements with Accountants on Accounting 34
and Financial Disclosure....................................
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 35
Item 11. Executive Compensation...................................... 35
Item 12. Security Ownership of Certain Beneficial Owners and 35
Management..................................................
Item 13. Certain Relationships and Related Transactions.............. 35
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 36
8-K.........................................................
Signatures ............................................................ 40
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PART I
When used in this Annual Report on Form 10-K, the words "intends,"
"expects," "plans," "estimates," "projects," "believes," "anticipates," and
similar expressions are intended to identify forward-looking statements. Except
for historical information contained herein, the matters discussed and the
statements made herein concerning the Company's future prospects are
"forward-looking statements" within the meaning of Section 27A of the Securities
Act and Section 21E of the Securities Exchange Act. Although the Company
believes that its plans, intentions and expectations reflected in such
forward-looking statements are reasonable, it can give no assurance that such
plans, intentions or expectations will be achieved. There can be no assurance
that future results will be achieved, and actual results could differ materially
from the forecast and estimates. Important factors that could cause actual
results to differ materially include, but are not limited to, worldwide business
and industry conditions (including consumer buying and retailer ordering
patterns), adoption of new hardware systems, product delays, changes in research
and development spending, software development requirements and their impact on
product launches, Company customer relations (in particular, levels of sales to
Wal-Mart and other mass merchants), retail acceptance of the Company's published
and third-party titles, competitive conditions and other risks and factors,
including, but not limited to, those discussed in "Factors Affecting Future
Performance" below at pages 9 to 15.
ITEM 1. BUSINESS
GENERAL
GT Interactive Software Corp., a Delaware corporation (the "Company" or
"GTIS"), is a leading worldwide developer, publisher and distributor of
interactive entertainment software for use on various platforms, including PCs,
Sony PlayStation and Nintendo 64. During calendar year 1998, the Company had the
third highest U.S. market share in number of units sold in the PC software game
category. The Company is also a leader in certain sub-segments of the
entertainment software market, including the fast growing children's education
and leisure entertainment segments. According to PC Data, in 1998 the Company
held the number one U.S. market share in the value-priced/leisure segment, on
the basis of both dollar and unit volume. In addition, during the same period,
the Company's Humongous studio held the number three U.S. market share in the PC
education software segment, on the basis of units sold.
The Company derives revenue from both publishing and distribution
activities. The Company's publishing business consists of three divisions:
Children's, Leisure and Frontline. The Company's Children's Division develops
and publishes children's educational and entertainment software for the personal
computer. GTIS' Leisure Division develops and publishes lower-priced PC
entertainment, reference and productivity titles for mass market consumption.
The Company's Frontline Division develops, internally and through third party
developers, and publishes cutting edge new release entertainment software for
the gaming enthusiast for use on multiple hardware platforms.
GTIS distributes both its own and third-party published software through an
established distribution network. The Company believes that it is one of the few
software publishers that sells its products directly to substantially all of the
major retailers of computer software in the U.S. This division also compiles,
repackages and markets older titles to retailers, extending the economic life of
those products. GTIS believes it is the largest distributor of consumer software
to mass merchants in the United States. GTIS supplies consumer software
(including its own and third-party published software) to approximately 2,380
Wal-Mart stores, approximately 2,165 K-mart stores and approximately 860 Target
stores. The Company also distributes consumer software to other major retailers
including Office Depot, Best Buy, CompUSA, AAFES, Sam's Club and Babbage's.
RECENT DEVELOPMENTS
On June 29, 1999, the Company announced that it had hired Bear Stearns &
Co. to seek a recapitalization, merger or sale of the Company. The Company also
announced that it received "Commitments" from affiliates of General Atlantic
Partners, LLC (together with its affiliates, "General Atlantic") and certain
members of the Cayre family to provide $30 million of subordinated debt
financing which will be made
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available to the Company on or before July 30, 1999. Effective immediately, but
conditioned upon the Commitments, the Banks who are party to the Company's $125
million credit facility (the "New Credit Agreement") have agreed to make
available to the Company an additional $20 million under the Company's borrowing
base until March 31, 2000. The Company anticipates that under the New Credit
Agreement, as amended, substantially all of the $125 million credit line should
be available to the Company through March 31, 2000. The Company believes that
amounts available under the New Credit Agreement and the Commitments will be
sufficient to fund its operational requirements through June 30, 2000, when the
New Credit Agreement becomes due and payable. This financing will also permit
the Company and Bear Stearns to seek a recapitalization, merger or sale of the
Company in an orderly manner and consistent with the needs of the Company's
ongoing business.
The Company is seeking a recapitalization, merger or sale because
management believes that in a consolidating industry, the Company's existing
capital resources are not adequate to carry out management's long-term strategic
objectives. There is no assurance, however, that any such transaction will be
completed. If such a transaction is not the subject of a definitive agreement
before December 31, 1999, or a transaction is not completed which results in
repayment of the New Credit Agreement and the Commitments, or such loans are not
extended or refinanced prior to June 30, 2000, the Company's operations and
financial condition could be materially and adversely affected. There is no
assurance that any such refinancing, if required, can be completed on favorable
terms, or at all.
PUBLISHING
The Company's publishing business consists of three divisions: Children's,
Leisure and Frontline. The Company's Frontline and Children's Divisions publish
premium priced, higher production-value titles for use on multiple platforms
that are developed internally or through third-party developers and marketed
both domestically and internationally. GTIS' Leisure segment publishes
value-priced PC titles for mass market consumption.
Children's Publishing
Humongous Entertainment, Inc. ("Humongous") is a leading developer and
publisher of interactive children's edutainment software. Humongous was acquired
by the Company in July 1996 and has been the primary vehicle through which the
Company has penetrated the children's edutainment market. Through internally
generated hit titles such as Freddi Fish, Putt Putt and Pajama Sam, and through
licensed products like Nickelodeon's Blue's Clues, Humongous has risen to become
the third-largest participant in the educational software market category
capturing 12% of total unit sales in the U.S. for the month of March 1999.
According to PC Data, Humongous published the best-selling (Blue's Clues ABC
Time Activities) and fourth best-selling (Blue's Clues Birthday Adventure)
edutainment titles of 1998. Other titles recently released by Humongous include
Putt-Putt(R) Enters the Race(TM), Putt-Putt(R) Travels through Time(TM),
Backyard Soccer(TM), Backyard Baseball(TM), Freddi Fish 4: The Case of the
Hogfish Rustlers of Briny Gulch(TM) and Pajama Sam 2: Thunder and Lightning
Aren't So Frightening(TM).
Leisure Publishing
The Leisure Division was established in June 1996 with the acquisition of
WizardWorks Group, Inc. ("WizardWorks"). Since that time, the Company has become
the leader in publishing value-priced leisure and recreational software.
The Company's Leisure Division publishes and distributes titles through
three labels:
WIZARDWORKS. In the fall of 1997, the Leisure Division virtually created a
brand new market when it introduced Deer Hunter for PC, under the WizardWorks
label. In approximately four months, this interactive hunting simulation game
went to the top of the PC Data charts to become the best-selling PC game in the
United States for the first six months of 1998. The phenomenon confirmed a
growing consumer trend in which the interest of those who typically do not play
computer games is increasingly sparked by a combination of compelling software
themes, new sub-$1,000 PC hardware and value software's sub-$20 price point.
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WizardWorks has since expanded the interactive outdoor sporting market with a
number of titles, including Deer Hunter II, Deer Hunter II Extended Season, Deer
Hunter's Extended Season, Deer Hunter Companion, Sporting Clays, Rocky Mountain
Trophy Hunter, Rocky Mountain Trophy Hunter II, Pro Bass Fishing, Deep Sea
Trophy Fishing, Bird Hunter Waterfowl Edition, Grand Slam Turkey Hunt, Alaskan
Expedition, Bird Hunter Upland Edition and African Safari Trophy Hunter 3D.
The Company's hunting software games for PC, published under the
WizardWorks brand, comprise more than 50% of the market share in units and
dollars for all hunting software games. GTIS has shipped approximately one
million units of its hit title Deer Hunter and approximately 800,000 units of
the sequel, Deer Hunter II. With all of the Company's sportsmen's titles
combined, GTIS has shipped a total of approximately 3.2 million units in the
hunting and fishing genre.
In fiscal year 1999, GTIS also published other titles under the WizardWorks
brand such as Montezuma's Return, Real Pool, Rudolf the Red-Nosed Reindeer's
Magical Sleigh Ride, Baseball Mogul and Carnivores, along with a number of other
titles targeted for the casual computer user.
COMPUWORKS. Under the CompuWorks brand the Company offers productivity and
small office/home office (SOHO) software products. GTIS has published such
recent CompuWorks titles as Joy of Cooking, America's Greatest Chili Cookbook,
National Golf Course Directory, Feng Shui, Holiday Card Creator '98, Yes 2K and
Learn Office 2000.
MACSOFT. The Company believes the MacSoft label is the leading Macintosh
games software publisher in the United States. MacSoft publishes front-line PC
Games for the Macintosh market, including GTIS-developed games, as well as
third-party games under license to GTIS. Recent successful titles published by
MacSoft include: Unreal, Civilization II: Gold Edition, Falcon 4.0, America's
Greatest Solitaire Games, Deer Hunter, Real Pool, Civilization II, and Quake.
Other recent titles published by MacSoft include: Lode Runner 2, Rocky Mountain
Trophy Hunter, Dark Vengeance, Klingon Honor Guard and America's Greatest Arcade
Hits 3D. MacSoft also publishes productivity titles including MacPublisher and
Desktop Labels Pro.
Frontline Publishing
The Company's Frontline Division is responsible for the development and
publishing of cutting edge, new release entertainment for the gaming enthusiast.
This division, which is the source of some of the industry's most successful
titles including Duke Nukem, Oddworld and Total Annihilation, has been a major
factor in the Company's leadership in the PC-based entertainment software
market. Frontline releases are largely responsible for the Company's third place
market share position in the PC games category for calendar year 1998 according
to PC Data. The Company has successfully exploited Frontline's strengths in
cutting edge PC entertainment software to gain entry into the high growth
videogame console platform market. In fiscal year 1999, approximately 62% of the
division's revenues were generated from sales of PlayStation, Nintendo and other
console software.
The Frontline Division publishes entertainment software developed by a
variety of wholly-owned and third party studios. Approximately 32% of
Frontline's fiscal year 1999 revenues were generated from products developed by
the Company's internally owned studios.
The Company has initiated efforts to reduce the number of new releases
published annually by the Front-line Division. In support of this effort, the
Company is in the process of closing two internal studios and is currently
reducing the size of another. This more selective approach to new releases is
expected to result in lower research and development costs, increased
efficiency, greater focus and more control over production schedules. A summary
description of each of Frontline's continuing internal studios is set forth
below.
Internal Development Studios
CAVEDOG ENTERTAINMENT. Cavedog, which was launched in late 1996, enabled
the Company to enter the real-time strategy game market. Cavedog published its
first front-line entertainment software title, Total Annihilation, in the fall
1997. Total Annihilation debuted amidst high praise and favorable reviews from
the world's gaming press and ultimately went on to ship more than one million
units worldwide and win more than
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45 industry awards of excellence. Shortly after its release, the game's website,
www.totalannihilation.com, was one of the 36 most visited websites on the
Internet and the third most visited gaming website. Cavedog also produced Total
Annihilation: Kingdoms, which was shipped in June 1999.
SINGLETRAC. In October 1997, the Company acquired SingleTrac Entertainment
Technologies, Inc., ("SingleTrac") the developer of hit PlayStation titles
including JetMoto I and II, Twisted Metal I and II and WarHawk. Since it was
acquired by GTIS, SingleTrac has produced Rogue Trip and Streak.
REFLECTIONS. The Company acquired Newcastle, England-based Reflections
Interactive Limited ("Reflections") in December 1998. Reflections was the
developer of PlayStation mega-hits Destruction Derby and Destruction Derby II.
In June 1999, the Company shipped approximately one million units of Driver,
Reflections' newest title.
LEGEND ENTERTAINMENT. The Company acquired Legend Entertainment Company
("Legend") in December 1998. Legend is currently developing a number of titles
for GTIS, including Unreal 2, Unreal Mission Pack I and Wheel of Time, for the
Company.
ODDWORLD INHABITANTS. In November 1996, the Company invested in
convertible preferred stock of Oddworld Inhabitants, Inc. ("Oddworld"), which is
convertible into 50% of the common equity of Oddworld. The Company also entered
into an exclusive worldwide publishing agreement with Oddworld. Since that time,
Oddworld has developed and shipped the first two successful installments of its
Oddworld series: Abe's Oddysee and Abe's Exoddus. Each title has sold more than
one million units worldwide.
Although the Company's past growth was enhanced in part by acquisitions, it
does not expect to make any acquisitions in the forseeable future, and the
Company's Credit Agreement, as amended on June 29, 1999, prohibits acquisitions
without the consent of the Banks.
External Product Development
Since its inception, the Company has established publishing and
distribution relationships with various independent developers. For the fiscal
year ended March 31, 1999, approximately 68% of the Company's Frontline
publishing revenues were derived from products developed by independent,
third-party developers. For example, the Duke Nukem franchise created by 3D
Realms has generated for the Company gross unit sales, including add-ons and
sequels, to date in excess of three million units worldwide. From May 1998
through March 1999, the Company shipped more than 800,000 units of Unreal, an
action title created by Epic Games.
Acquired titles are marketed under the Company's name as well as the name
of the original developer. The agreements with third-party developers provide
the Company with exclusive publishing and distribution rights for a specific
period of time for specified platforms and territories. Those agreements may
grant to the Company the right to publish sequels, enhancements and add-ons to
the product originally being developed and produced by the developer. In
consideration for its services, the developer receives a royalty based on sales
of the product that it has developed. A portion of this royalty may be pre-paid,
with payments tied to the completion of detailed performance milestones.
The Company manages the production of external development projects by
appointing a producer to oversee the product's development and to work with the
third-party developer to design, develop and test the software. This producer
also helps ensure that performance milestones are met in a timely manner. The
Company generally has the right to cease making payments to an independent
developer if such developer fails to complete its performance milestones in a
timely fashion.
DISTRIBUTION
The Company's strength in distribution ensures access to valuable shelf
space for its published product. The Company believes that it is one of the few
software publishers that sells directly to substantially all of the major
retailers of computer software in the United States and that it is the largest
distributor of computer software to mass merchants in the United States. GTIS
supplies consumer software (including its own and
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third-party published software) to approximately 2,380 Wal-Mart stores,
approximately 2,165 K-mart stores and approximately 860 Target stores.
The Company also distributes consumer software (including its own and
third-party published software) to other major retailers including Office Depot,
Best Buy, CompUSA, AAFES, Sam's Club and Babbage's. The Company values its
distribution relationship with these major retailers because it also allows the
Company to more readily sell its own, higher margin software to them.
TECHNOLOGY. Utilizing its point-of-sale replenishment systems and
electronic data interchange ("EDI") links with its largest mass merchant
accounts, the Company is able to handle high sales volumes to those customers
efficiently, manage and replenish inventory on a store-by-store basis and
assemble for its customers regional and store-by-store data based on product
sell-through. The Company utilizes proprietary technology systems for order
processing, inventory management, purchasing and tracking of shipments thereby
increasing the efficiency and accuracy of order processing and payments and
shortening order turnaround time. These systems automatically track software
orders from order processing to point-of-sale, thereby enhancing customer
satisfaction through prompt delivery of the desired software titles.
FULFILLMENT. Historically, the Company's warehouse operations provided
fulfillment services within North America to the Company and third party
developers. Such services included physical receipt and storage of inventory and
its distribution to the mass market and other retailers. After evaluating the
costs associated with the fulfillment function, including, among other things,
the costs of projected future investments in plant and technology, the Company
has decided to outsource its warehouse operations to a third-party vendor
beginning in July 1999.
DISTRIBUTION OF THIRD PARTY PRODUCTS. Based on the strength of its current
consumer software distribution operation, the Company has successfully attracted
other publishers to utilize its mass merchant distribution capabilities for
their products. Such products are generally acquired by the Company and
distributed under the name of the publisher who is, in turn, responsible for the
publishing, packaging marketing and customer support of such products. The
Company's agreements with other publishers typically provide for certain retail
distribution rights in designated territories for a specific period of time,
after which those rights are subject to negotiated renewal.
VALUE/CLOSE-OUT. In June 1995, GTIS acquired Slash Corporation, a leading
publisher, merchandiser and distributor of value-priced software. The
value/close-out business purchases older titles, late in their product life
cycles, from other publishers and sells them as "value" titles to retailers.
This helps the publisher extend the life cycle of its products. The products are
intended for retail price points of $4.98 to $19.99 and may include boxed
products as well as product in jewel cases. The value/close-out business may
purchase finished goods or may license the rights to produce finished goods from
the publisher. The Company sells value programs to some retailers in which the
Company is responsible for stocking a four-foot or eight-foot section in the
retailers' stores.
AFFILIATE LABEL PROGRAM. During 1997, the Company launched its Affiliate
Label Program. Affiliates have included Empire Interactive, SegaSoft, Melbourne
House, Strategy First, HomeStyles Interactive and Project Two. Under this
program, the Company sells and distributes interactive software for, and
provides marketing consulting services to, a variety of publishers on a global
basis. The Affiliate Label Program is provided on a fee-for-service basis,
without the Company taking ownership of the inventory.
GEOGRAPHY
The Company is geographically diversified. In January 1995, the Company
established a publishing operation in London, England with responsibility for
European markets. In November 1996, the Company acquired the business of Warner
Interactive Europe, a European subsidiary of Warner Music Group. As a result of
its acquisitions, the Company now has international offices in the United
Kingdom, Germany, France, Benelux and Australia. Including the United States,
the Company currently publishes and distributes its titles in 39 countries
worldwide.
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The Company's international business has grown significantly in recent
years, from revenues of $53 million in fiscal year 1997 to $132 million in
fiscal year 1999. Sixty two percent of the Company's Frontline publishing
revenue for fiscal year 1999 was generated from international sales, versus 60%
in fiscal year 1998 and 42% in fiscal year 1997. The Company plans to continue
to pursue profitable opportunities to establish additional direct operations in
Europe, South America and the Far East.
Since 1997, the Company has established a physical presence for the Leisure
Division in each of Europe's major markets, including the United Kingdom
(through the acquisition of One Stop Direct Limited ("One Stop") in 1997),
Germany (through the acquisition of Prism Leisure Tontragervertriebs GmbH
("Prism") in 1998), France and the Benelux, as well as Australia. Because of the
increasing volume of leisure publishing performed by the Company in Europe, the
Company centralized its European leisure publishing function in fiscal year
1999. The Company intends to grow its international leisure operations (i) in
tandem with the growth of low price PCs around the world, (ii) through the
worldwide roll-out of its domestic leisure product line and (iii) through
acquisitions of local content developers.
The Company is also pursuing an international high growth strategy for its
Children's Division products. As third party licenses with local publishers
expire for Humongous products, the Company is selling these products directly in
its foreign territories, supported by localization efforts at Humongous. The
Company is also looking to international markets to expand its direct-to-retail
sales and distribution presence.
SALES AND MARKETING
The Company utilizes a wide range of sales and marketing techniques to
promote sales of its products including (i) in-store promotions utilizing
display towers and endcaps, (ii) advertising in computer and general consumer
publications, (iii) on-line marketing, (iv) direct mailings and (v) television
advertising. The Company monitors and measures the effectiveness of its
marketing strategies throughout the product lifecycle. Historically, the Company
has devoted a substantial amount of its marketing resources to its Frontline
published products and intends to do so in the future. The Company believes that
such marketing is essential for cultivating product successes and brand-name
loyalty.
The Company's marketing programs have expanded along with the Company's
publishing business, with an emphasis both on launching products and on raising
the public's awareness of new brands and franchises. The Company may begin to
develop an integrated marketing program for a product more than a year in
advance of its release. This integrated marketing approach may include extensive
press contacts, development of point-of-purchase displays, print and television
advertising, Internet promotion, press events and a global synchronized launch.
The Internet is an integral element of the Company's marketing efforts
used, in part, to generate awareness for titles months prior to their market
debut. The Company incorporates the Internet into its marketing programs through
the creation of product-dedicated mini-sites and on-line promotions. In
addition, the Company provides editorial material to on-line publications that
reach the core gaming audience.
To capitalize on the innovative nature of its products, the Company has
developed a public relations program that has resulted in coverage for the
Company by trade journals and also by well-recognized publications such as The
New York Times, Entertainment Weekly, Newsweek and USA Today. Among the
marketing strategies the Company utilizes is the creation of special press
events to coincide with the launch of a new product. The Company also uses
independent field sales representative organizations to assist in servicing its
mass merchant accounts.
In fiscal year 1999, the Company consolidated its three North American
sales organizations into a single sales organization in order to improve the
efficiency of its sales effort. The Company has 14 customer sales
representatives who serve as the primary GTIS contacts with the Company's
largest 25 customers. In addition the Company has five divisional sales
representatives who work with the Company's customer sales representatives and
their customers to help provide leadership and direction to the Company's
selling efforts.
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In Europe, the Company has a sales force in each of the countries in which
it has direct operations: England, France, Germany and the Benelux. All other
territories in Europe, Asia Pacific, Latin America and the Middle East are
serviced by an exclusive distributor network.
OPERATIONS
Beginning in July 1999, the Company will outsource its warehouse operations
in the United States to Arnold Logistics ("Arnold"). The warehouse operations
include the receipt and storage of inventory as well as the distribution of
inventory to mass market and other retailing customers. In connection with the
outsourcing agreement, the Company expects to discontinue the use of its Edison,
New Jersey facilities for warehouse operations, as well as terminate the
approximately 525 employees performing related services for the Company.
The Company decided to enter into the agreement with Arnold because (i) the
Company's business already exceeded the capacity of its Edison distribution
center, and the agreement with Arnold permitted the Company to avoid investing
significant capital in a new distribution center and warehouse management
system, (ii) Arnold could provide more efficient warehouse operations than the
Company, (iii) the cost of outsourcing its warehouse operations to Arnold is
expected to be less than the Company's cost to provide these services
internally, and (iv) Arnold charges the Company on a variable basis, based on
the Company's volume, while the Company's costs for its own warehouse operations
were of a fixed nature.
The Company's CD-ROM disk duplication is contracted out to a number of
third-party disk duplication companies. Printing of user manuals and of
packaging materials is performed to the Company's specifications by outside
sources. Disks, user manuals and sales brochures are, for the most part,
assembled for sale by the Company. To date, GTIS has not experienced any
material difficulties or delays in the manufacture and assembly of its products,
or material returns due to product defects. No concentration for the supply of
the Company's publishing needs currently exists and a number of vendors are
available.
Sony and Nintendo manufacture the Company's products that are compatible
with their respective video game consoles, as well as the manuals and packaging
for such products, and ship finished products to the Company for distribution.
PlayStation products consist of proprietary format CD-ROMs and are typically
delivered to the Company by Sony within a relatively short lead time.
Manufacturers of Nintendo and other video game cartridges typically deliver
software to the Company within 45 to 60 days after receipt of a purchase order.
EMPLOYEES
As of March 31, 1999, the Company had 1,693 employees worldwide.
Domestically, there were a total of 1,513 employees with 139 in administration
and finance, 94 in operations, 145 in sales and marketing, 471 in product
development and 664 in manufacturing and distribution. Included in the 664 for
manufacturing and distribution are 565 employees who are members of Local 734 of
the L.I.U. of N.A. of the AFL-CIO (the "Union"). The Union employees are all
located at the Edison, New Jersey distribution center and are subject to a
collective bargaining agreement between the Company and the Union which expires
on May 31, 2001. When the Company outsources its distribution to Arnold
beginning in August 1999, approximately 525 of the Company's employees will be
terminated, of whom approximately 465 belong to the Union.
Internationally, as of March 31, 1999, the Company had 180 employees with
52 in administration and finance, 11 in operations, 78 in sales and marketing,
37 in product development and two in distribution.
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FACTORS AFFECTING FUTURE PERFORMANCE
WE CANNOT ASSURE YOU THAT WE WILL BE ABLE TO COMPLETE A RECAPITALIZATION,
MERGER OR SALE OF GTIS. In addition, the process of seeking a recapitalization,
merger or sale of GTIS may disrupt our ongoing business and distract our
management and workforce from the day-to-day operations of GTIS. If we fail to
sign a definitive agreement for a recapitalization, merger or sale of GTIS by
December 31, 1999, then the amounts outstanding under the New Credit Agreement
may be accelerated.
AS A RESULT OF THE NEW CREDIT AGREEMENT AND THE COMMITMENTS, WE HAVE
SUBSTANTIAL INDEBTEDNESS. After giving effect to the New Credit Agreement and
the Commitments, our total indebtedness could be as high as $155 million. The
level of our indebtedness could have negative consequences to us including the
following:
- our ability to obtain additional financing in the future for working
capital, capital expenditures, debt service requirements or other
purposes may be limited;
- a substantial portion of our cash flow from operations must be dedicated
to the payment of interest on our indebtedness and other obligations and
will not be available for use in our business; and
- our substantial indebtedness may make us more vulnerable to economic
downturns and may limit our ability to withstand competitive pressures.
WE MAY NEED ADDITIONAL FINANCING. Although we believe that financing from
the New Credit Agreement and the Commitments will provide sufficient amounts to
fund our anticipated operations through June 30, 2000 and to seek a
recapitalization, merger or sale of GTIS in an orderly manner, we cannot assure
you that we will not require additional financing before that time. If we do
need additional financing, or we must refinance the New Credit Agreement and the
Commitments on or before June 30, 2000, we cannot assure you that such financing
will be available on favorable terms, or at all.
THE NEW CREDIT AGREEMENT WILL RESULT IN THE DILUTION OF OUR COMMON
STOCK. We are required to issue warrants to purchase a total of 2,275,000
shares of our common stock, at an exercise price equal to par value, before July
30, 1999, in connection with the funding of the New Credit Agreement and the
Commitments. In addition, the terms of the New Credit Agreement and the
Commitments provide for the issuance of significant additional warrants to our
debtholders if we do not sign an agreement for a recapitalization, merger or
sale of GTIS which provides for the repayment of these debt facilities by
October 31, 1999 and complete the transaction by February 28, 2000. If we do not
sign an agreement for a recapitalization, merger or sale of GTIS by October 31,
1999, we will be required to issue warrants, at an exercise price equal to par
value, to purchase a total of an additional 2,750,000 shares of our common
stock. If we do not complete a recapitalization, merger or sale of GTIS by
February 28, 2000, we will be required to issue an additional 3,225,000
warrants, and if we do not repay the Commitments by June 30, 2000, we will be
required to issue 3,000,000 additional warrants each fiscal quarter until we
make repayment.
THE LOSS OF WAL-MART AS A KEY CUSTOMER COULD NEGATIVELY AFFECT OUR
BUSINESS. Our sales to Wal-Mart accounted for approximately 29% of net revenues
for the fiscal year ended March 31, 1999 and our accounts receivable from
Wal-Mart were approximately $49.1 million at March 31, 1999. Our business,
operating results and financial condition would be adversely affected if:
- we lost Wal-Mart as a customer,
- we began shipping fewer products to Wal-Mart,
- we were unable to collect receivables from Wal-Mart, or
- we experienced any other adverse change in our relationship with
Wal-Mart.
We do not have any written agreements or understandings with Wal-Mart.
Consequently, our relationship with Wal-Mart could end at any time. We cannot
assure you that Wal-Mart will continue to use us a major supplier of consumer
software, or at all. During the second half of 1997, Wal-Mart began purchasing
software directly from five publishers whose software was previously sold to
Wal-Mart through GTIS. During 1998 and
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1999, Wal-Mart has continued, and can be expected to continue, to buy software
directly from other publishers, rather than purchasing software through GTIS.
These direct purchases could significantly reduce our sales to Wal-Mart. For
example, Wal-Mart has recently announced that it expects to begin purchasing
products directly from Microsoft and Activision in fiscal year 2000. Our
combined net revenues from sales of those products to Wal-Mart totaled
approximately $47.3 million in the fiscal year ended March 31, 1999.
OUR REVENUES WILL DECLINE AND OUR COMPETITIVE POSITION WILL BE ADVERSELY
AFFECTED IF WE ARE UNABLE TO INTRODUCE NEW PRODUCTS ON A TIMELY BASIS. Our
continued success in the publishing business depends on the timely introduction
of successful new products, sequels or enhancements of existing products to
replace declining revenues from older products. A significant delay in
introducing new products, sequels or enhancements could materially and adversely
affect the ultimate success of our products and, in turn, our business,
operating results and financial condition, particularly in view of the
seasonality of our business. For example, we recently announced that the
introduction of five major titles was delayed from the fourth quarter of fiscal
year 1999 to the first half of fiscal year 2000, significantly contributing to
operating losses during the fourth quarter of fiscal year 1999. The process of
introducing new products, sequels or product enhancements is extremely difficult
and will only become more difficult as new platforms and technologies emerge.
Competitive factors in our industry demand that we create increasingly
sophisticated products, which in turn makes it difficult to produce and release
these products on a predictable schedule.
WE MAY BE UNABLE TO DEVELOP, MARKET AND PUBLISH NEW PRODUCTS IF WE ARE
UNABLE TO SECURE OR MAINTAIN RELATIONSHIPS WITH INDEPENDENT SOFTWARE
DEVELOPERS. Although we substantially increased our internal software
capabilities in 1996, 1997 and 1998, we are still dependent, to a meaningful
degree, upon independent software developers. For the fiscal year ended March
31, 1999, approximately 68% of our Frontline publishing revenues were derived
from products developed by independent developers. Consequently, our success
depends in part on our continued ability to obtain and/or renew product
development agreements with independent developers. However, we cannot assure
you that we will be able to obtain or renew these product development agreements
on favorable terms, or at all; nor can we assure you that we will be able to
obtain the rights to sequels of successful products which were originally
developed by independent developers for GTIS. In addition, many of our
competitors have greater access to capital than we do, which puts us at a
competitive disadvantage when bidding to attract independent developers to enter
into publishing agreements with us.
Our agreements with independent software developers are easily terminable,
often without notice, if either party declares bankruptcy, becomes insolvent,
ceases operations or materially breaches its agreement and fails to cure that
breach within a designated time frame. In addition, many independent software
developers have limited financial resources. Many are small companies with a few
key individuals without whom a project may be difficult or impossible to
complete. Consequently, we are exposed to the risk that these developers will go
out of business before completing a project, or simply cease work on a project,
for which we have hired them.
COMPETITION FOR INDEPENDENT SOFTWARE DEVELOPERS IS INTENSE AND MAY PREVENT
US FROM SECURING OR MAINTAINING RELATIONSHIPS WITH INDEPENDENT SOFTWARE
DEVELOPERS. We may be unable to secure or maintain relationships with
independent developers if our competitors can offer them better shelf access,
better marketing support, more development funding, higher royalty rates, or
other selling advantages. Even if these independent developers have developed
products for us in the past, we cannot assure you that they will continue to
develop products for us in the future. In fact, we have in the past worked with
independent developers who later entered into agreements with our competitors
because of our competitor's ability or willingness to pay higher royalty rates
and/or advances.
INDEPENDENT DEVELOPERS MAY PUBLISH THEIR OWN PRODUCTS INSTEAD OF USING GTIS
TO PUBLISH AND DISTRIBUTE THEIR PRODUCTS, OR MAY SIGN PUBLICATION AGREEMENTS
WITH OUR COMPETITORS, EITHER OF WHICH MAY ADVERSELY AFFECT OUR ABILITY TO
DEVELOP, MARKET AND PUBLISH NEW PRODUCTS. For example, in January 1998, a
consortium, in which certain independent developers purport to have ownership
interests, announced that it secured publishing rights with respect to software
titles to be produced by these developers. These developers include Apogee
Software (3D Realms), developer of Duke Nukem and Prey, and Epic Games,
developer of Unreal. Although the consortium also announced that these
developers will honor their existing obligations to other
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software publishers, we do not know if the competitive pressures exerted by the
consortium will inhibit us from establishing and maintaining relationships with
independent software developers in the future. For example, it was recently
announced that Apogee Software (3D Realms) has agreed to publish one of the
future sequel Duke Nukem titles through one of our competitors.
AS OUR PAYMENT OF ADVANCES AND GUARANTEED ROYALTIES TO INDEPENDENT
DEVELOPERS INCREASES, WE FACE THE RISK THAT OUR OPERATING RESULTS MAY SUFFER IF
WE ARE UNABLE TO RECOVER THESE PREPAID ROYALTIES. In connection with our
licensing agreements with independent developers and licensors, we had
approximately $9.2 million of royalty advances, associated with multi-year
output contracts, on our balance sheet as of March 31, 1999. We cannot assure
you that current or future royalty advances will be recouped. Our ability to
receive revenue and recoup these advances may be prevented or delayed if:
- we fail to release the products associated with royalty advances,
- we experience a delay in the release of these products, or
- sales of these products do not cover the advances made.
FLUCTUATIONS IN OUR QUARTERLY NET REVENUES AND OPERATING RESULTS MAY RESULT
IN REDUCED PROFITABILITY AND LEAD TO REDUCED PRICES FOR OUR STOCK. Our
quarterly net revenues and operating results have varied in the past and can be
expected to vary in the future. As a result, we cannot assure you that we will
be consistently profitable on a quarterly or annual basis. If our operating
results in any future quarter fall below the expectations of market analysts or
investors, the price of our common stock will likely decrease.
Our business has experienced, and is expected to continue to experience,
significant seasonality. Typically, our net sales are significantly higher
during the fourth calendar quarter because of increased consumer demand during
the year-end holiday season. In other calendar quarters, our net revenues may be
lower and vary significantly.
OUR REVENUE GROWTH AND COMPETITIVE POSITION MAY BE ADVERSELY AFFECTED IF WE
ARE UNABLE TO ANTICIPATE AND ADAPT TO RAPIDLY CHANGING TECHNOLOGY. The consumer
software industry is characterized by rapidly changing technology. The
introduction of new technologies, including new technologies that support multi-
player games and new media formats such as on-line delivery and digital video
disks (DVDs), could render our previously released products obsolete or
unmarketable. We must continually anticipate the emergence of, and adapt our
products to, new technologies and systems. In addition, the development cycle
for products designed to operate on new systems can be significantly longer than
our current development cycles. When we choose to publish or develop a product
for a new system, we may need to make a substantial development investment one
or two years in advance of when we actually ship products for that system. If we
develop products for a new system that is ultimately unpopular, our expected
revenues from that product will suffer and we may not be able to recoup our
investment. Conversely, if we choose not to publish products for a new system
that is ultimately popular, our revenue growth and competitive position may be
adversely affected. While 32 and 64 bit game systems, such as Sony PlayStation
and Nintendo 64, continue to be popular and their installed base has reached
significant levels in the US and worldwide, new systems are being developed. For
example, Sony recently announced the development of its next-generation
PlayStation, a 128 bit system which, among other things, will incorporate DVD
technology. Sony plans to introduce its next generation PlayStation in Japan by
March 2000 and in its overseas markets by fall 2000. If successfully developed,
these new systems would require us to reassess our commitment to 32 and 64 bit
game systems and/or any new systems which are introduced.
BECAUSE SOME LICENSORS HAVE SIGNIFICANT CONTROL OVER OUR PRODUCTS, THE
COSTS OF DEVELOPING AND MANUFACTURING THOSE PRODUCTS MAY INCREASE. We are
required to obtain a license to develop and distribute software for each of the
video game systems for which we develop products. We currently have licenses
from Sony, to develop products for the Sony PlayStation, and Nintendo, to
develop products for Nintendo 64. Our contracts with Sony and Nintendo often
grant them significant control over the manufacturing of GTIS
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products. For example, we are obligated to submit new games to Sony or Nintendo
for approval prior to development and/or manufacture. In some circumstances,
this could adversely affect GTIS by:
- leaving GTIS unable to have its products manufactured and shipped to
customers,
- increasing manufacturing lead times and expense to us over the lead times
and costs we could achieve independently,
- delaying the manufacture and, in turn, the shipment of products, and
- requiring GTIS to take significant risks in prepaying for and holding its
inventory of products.
These factors could materially and adversely affect our business, operating
results and financial condition.
THE LOSS OF OUR SENIOR MANAGEMENT AND SKILLED PERSONNEL COULD NEGATIVELY
AFFECT OUR BUSINESS. In early 1999, we replaced our three most senior executive
officers. Our success will depend to a significant degree upon the performance
and contribution of our senior management team and upon our ability to attract,
motivate and retain highly qualified employees with technical, management,
marketing, sales, product development and other creative skills. In the computer
software industry, competition for highly skilled and creative employees is
intense and costly. We expect this competition to continue for the foreseeable
future, and we may experience increased costs in order to attract and retain
skilled employees.
We cannot assure you that we will be successful in attracting and retaining
skilled personnel. Although we have entered into employment agreements with
Thomas Heymann, as Chairman of the Board and Chief Executive Officer of the
Company, and John Baker, as President and Chief Operating Officer of the
Company, we cannot assure you that these individuals or other senior management
will not leave or compete against us. Our business, operating results and
financial condition could be materially and adversely affected if we lost the
services of these or other senior employees or if we fail to replace other
employees who leave or to attract additional qualified employees. Our recent
announcement that we will be seeking a recapitalization, merger or sale of GTIS
may make it more difficult to retain or attract qualified employees.
THE GENERAL ECONOMIC AND POLITICAL RISKS OF DOING BUSINESS ABROAD COULD
NEGATIVELY AFFECT OUR BUSINESS IN INTERNATIONAL MARKETS. In the past three
years, we have materially increased our international revenues. International
publishing revenues accounted for approximately 31%, 48%, 48% and 44%, of
publishing revenues for the years ended December 31, 1996 and 1997, the three
months ended March 31, 1998 and the twelve months ended March 31, 1999,
respectively. We expect that international revenues will account for a
significant portion of our net revenues in the future. However, in addition to
the possibility that our international business will not continue to grow at the
same rate as in the past, our international revenues are subject to the general
risks of doing business abroad, including:
- unexpected changes in regulatory requirements, tariffs and other
barriers,
- fluctuating exchange rates,
- potential political instability,
- difficulties installing and managing foreign operations,
- difficulties collecting accounts receivable,
- costs and difficulties of localizing products for use in foreign markets
and
- inability of foreign laws to protect our proprietary rights to the same
extent as U.S. law, particularly in some international markets such as
South America, the Middle East, the Pacific Rim and the Far East where
software piracy presents a particularly acute problem.
We cannot assure you that these or other factors will not have a material
adverse effect on our future international revenues and, consequently, on our
business, operating results and financial condition.
SIGNIFICANT COMPETITION IN OUR INDUSTRY COULD ADVERSELY AFFECT OUR
BUSINESS. The market for our products is highly competitive and relatively few
products achieve significant market acceptance. Currently,
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we compete primarily with other publishers of interactive entertainment software
for both personal computers and video game consoles. Our competitors include
Electronic Arts Inc., Mattel Inc., Hasbro Corporation, Havas SA, a French
company, and Activision. In addition, some large software companies, media
companies and film studios, such as Walt Disney Company, who are increasing
their focus on the interactive entertainment and edutainment software market,
may become significant competitors of GTIS. As compared to GTIS, many of our
current and future competitors may have significantly greater financial,
technical and marketing resources than we do. As a result, these current and
future competitors may be able to:
- respond more quickly to new or emerging technologies or changes in
customer preferences,
- carry larger inventories,
- undertake more extensive marketing campaigns,
- adopt more aggressive pricing policies and
- make higher offers or guarantees to software developers and licensors
than GTIS.
We may not have the resources required for us to respond effectively to
market or technological changes or to compete successfully with current and
future competitors. Increased competition may result in price reductions,
reduced gross margins and loss of market share, any of which could have a
material adverse effect on our business, operating results or financial
condition. We cannot assure you that we will be able to successfully compete
against our current or future competitors or that competitive pressures will not
have a material adverse effect on our business, operating results and financial
condition.
REVENUES FROM OUR DISTRIBUTION BUSINESS MAY DECLINE AS COMPETITION
INCREASES AND INTERNET TECHNOLOGY IMPROVES. During the fiscal year ended March
31, 1999, revenues from our distribution business were approximately 48% of net
revenues. Recently, several of our competitors have sought to expand their
distribution capabilities and Wal-Mart has announced plans to purchase products
directly from Microsoft and Activision. New video game systems and electronic
delivery systems may be introduced into the software market and potential new
competitors may enter the software development and distribution market,
resulting in greater competition. In addition, revenues from our distribution
business may be adversely affected as Internet technology is improved to enable
consumers to purchase and download full-version software products or order
products directly from publishers or from unauthorized or illegal pirate sources
over the Internet.
REVENUES FROM OUR DISTRIBUTION BUSINESS MAY DECLINE IF THE THIRD-PARTY
PRODUCTS WHICH WE DISTRIBUTE FOR OTHER COMPANIES BECOME UNAVAILABLE TO US. As
part of our distribution program, we provide our mass merchant customers with a
wide variety of titles. To achieve this product mix, we must supplement the
distribution of our published products with third-party software products,
including products published by our competitors. We cannot assure you that these
competitors will continue to provide us with their products for distribution to
our mass merchant customers. Our inability to obtain software titles developed
or published by our competitors, coupled with our inability to obtain these
titles from other distributors, could have a material adverse effect on our
relationships with our mass merchant customers and our ability to obtain shelf
space for our own products. This, in turn, could have a material adverse effect
on our business, operating results and financial condition.
WE MAY FACE INCREASED COMPETITION AND DOWNWARD PRICE PRESSURE IF WE ARE
UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS. Our success is heavily
dependent upon our confidential and proprietary intellectual property. We sell a
significant portion of our published software under licenses from independent
developers and, in these cases, we do not acquire the copyrights for the
underlying work. We rely primarily on a combination of confidentiality and
non-disclosure agreements, patent, copyright, trademark and trade secret laws,
as well as other proprietary rights laws and legal methods, to protect our
proprietary rights and the rights of our developers. However, current U.S. and
international laws afford us only limited protection. Despite our efforts to
protect our proprietary rights, unauthorized parties may attempt to copy our
products or obtain and use information that we regard as proprietary. Software
piracy is a persistent problem in the computer software industry. Policing
unauthorized use of our products is extremely difficult because consumer
software can be easily duplicated and disseminated. Furthermore, the laws of
some foreign countries may not protect our
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proprietary rights to as great an extent as U.S. law. Software piracy is a
particularly acute problem in some international markets such as South America,
the Middle East, the Pacific Rim and the Far East. Our business, operating
results and financial condition could be materially and adversely affected if a
significant amount of unauthorized copying of our products were to occur. We
cannot assure you that our attempts to protect our proprietary rights will be
adequate or that our competitors will not independently develop similar or
competitive products.
WE MAY FACE INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS WHICH WOULD BE COSTLY
TO RESOLVE. As the number of available software products increase, and their
functionality overlaps, software developers and publishers may increasingly
become subject to infringement claims. We are not aware that any of our products
infringe on the proprietary rights of third parties. However, we cannot assure
you that third parties will not assert infringement claims against GTIS in the
future with respect to current or future products. There has been substantial
litigation in the industry regarding copyright, trademark and other intellectual
property rights. We have also initiated litigation to assert our intellectual
property rights. Whether brought by or against GTIS, these claims can be
time-consuming, result in costly litigation and divert management's attention
from the day-to-day operations of GTIS, which can have a material adverse effect
on our business, operating results and financial condition.
WE MAY BE AT A COMPETITIVE DISADVANTAGE IF WE ARE UNABLE TO SUCCESSFULLY
IMPLEMENT OUR INTERNET STRATEGY. To take advantage of Internet opportunities,
we have, and will continue to:
- expand our World Wide Web sites and the development of our Internet
infrastructure and capabilities;
- expand our electronic distribution capabilities;
- incorporate on-line functionality into existing products; and
- develop and invest in new Internet-based businesses and products,
including multi-player entertainment products.
Implementing our Internet strategy has been costly. We have incurred, and
expect to incur, significant additional costs in connection with these efforts.
These costs include those associated with the acquisition and maintenance of
hardware and software necessary to permit on-line commerce and multi-player
games, as well as the related maintenance of our website and personnel. Although
we believe these platforms and technologies are an integral part of our
business, we cannot assure you that our Internet strategy will be successful or
that we will be able to recoup the cost of our investment.
WE ARE CURRENTLY IN LITIGATION WHICH COULD BE COSTLY IF WE LOSE. As
described under Item 3, "Legal Proceedings," GTIS is currently a defendant, or
subject to counterclaims, in a number of lawsuits. In all of these lawsuits, we
believe that the plaintiffs' complaints are without merit. Although we intend to
defend ourselves vigorously against these actions, doing so is costly and
time-consuming and may divert management's attention from our day-to-day
operations. In addition, we cannot assure you that these actions will be
ultimately resolved in our favor or that an adverse outcome will not have a
material adverse effect on our business, operating results and financial
condition.
IF ACTUAL RETURNS EXCEED OUR RETURN RESERVE, OUR BUSINESS MAY BE NEGATIVELY
AFFECTED. To cover returns, we establish a return reserve at the time we ship
our products. We estimate the potential for future returns based on historical
return rates, seasonality of sales, retailer inventories of GTIS products, and
other factors. Historically, we have experienced product returns at a rate of
approximately 30% of gross revenues. While we are able to recover the majority
of our costs when third-party products are returned, we bear the full financial
risk when our own products are returned. In addition, the license fees we pay
Sony and Nintendo are non-refundable and we cannot recover these fees when our
console products are returned. Although we believe we maintain adequate reserves
with respect to product returns, we cannot assure you that actual returns will
not exceed reserves, which could adversely affect our business, operating
results and financial condition.
OUR PRODUCTS, SYSTEMS AND SALES MAY BE SUBJECT TO YEAR 2000 PROBLEMS. We
have reviewed our critical information systems and other technology for Year
2000 compliance and we are correcting any deficiencies through normal upgrades
of our software or, when necessary, through replacement of existing software or
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affected systems with Year 2000 compliant applications or systems. However, if
our present efforts to address Year 2000 compliance issues are not successful,
our business, operating results and financial position could be materially and
adversely affected. For example, failure to achieve Year 2000 compliance for our
internal critical information systems could delay our ability to manufacture and
ship products, disrupt customer service and technical support facilities, or
interrupt customer access to online products and services. In addition, because
of the number of products sold by GTIS currently and in the past, we could face
litigation relating to Year 2000 compliance of products that we no longer sell
and/or support, although we believe that any such exposure should not be
material.
Furthermore, our business is heavily dependent upon third parties such as
vendors, suppliers, service providers and a large retail distribution channel.
We have asked vendors and other third parties with whom we have relevant
relationships to certify that they are Year 2000 compliant or, if they are not,
to provide us with a description of their plans to become so. However, if these
vendors or other third parties experience Year 2000 failures or malfunctions,
our ability to conduct ongoing operations could be materially and adversely
affected. For example, our ability to manufacture and ship products (including
our own and third-party published software) into the retail channel, to receive
retail sales information necessary to maintain proper inventory levels or to
complete online transactions dependent upon third party service providers could
be affected. In addition, should third-party published products distributed by
GTIS fail to be Year 2000 compliant, especially any utility software which, if
not Year 2000 compliant could corrupt a user's hardware system, our retail
customers might return these products or seek redress from us, which in turn
would require us to seek redress from the publisher of the product.
THE START-UP OF OUR OUTSOURCING CONTRACT FOR WAREHOUSE OPERATIONS COULD
CREATE OPERATING DIFFICULTIES. We recently entered into an agreement with an
outside vendor to have all of our physical inventory (including returns) handled
and shipped by that vendor from its plant in Pennsylvania. While we believe that
this outsourcing of our warehouse operations will result in more efficient and
cost effective operations for the Company, we cannot assure you that the process
of the changeover to the vendor's facility (scheduled for August 1999) will not
create unforeseen operating difficulties or adversely affect our warehouse
operations and our relationships with our retail customers.
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ITEM 2. PROPERTIES
The Company's principal administrative, sales, marketing and development
facilities are located in approximately 90,000 square feet of space at 417 Fifth
Avenue in New York City under a lease expiring in 2007, which commenced in
December 1996. The Company sublets approximately 4,700 square feet of its office
space to Five Partners Asset Management LLC ("Five Partners"), a company
affiliated with Joseph J. Cayre, Chairman Emeritus of the Board of Directors.
The Company believes that the terms of this lease are no less favorable to the
Company than those it could obtain from independent third parties.
The Company maintains a 192,900 square foot distribution center and a
70,000 square foot return center in Edison, New Jersey under leases that expire
in December 1999 and May 2000, respectively.
Certain product development and marketing divisions are located in
approximately 7,600 square feet of office space in San Francisco, CA, under a
lease that expires in November 2003.
The Leisure Division has a lease for 240,000 square feet of office,
warehouse and distribution space in the Plymouth, Minnesota area that expires in
September 1999. The division has entered into a new lease for office space in
Plymouth, Minnesota for 23,400 square feet expiring in February 2003.
In Scottsdale, Arizona, the Company maintains two leases: a 25,000 square
foot office space under a lease expiring in March 2006 which has been sublet for
the remaining term, and a 2,900 square foot office space under a lease expiring
in May 2000.
The Company has leased approximately 83,000 square feet of office space
under two separate leases to house its Humongous subsidiary in Bothell,
Washington, under leases expiring in May 2008 and June 2004.
The Company has assumed leases for certain of its acquisitions and entered
into leases for certain of its internal development studios, totaling
approximately 87,000 square feet with lease expiration dates from August 1999
through September 2010. These properties are located in Utah, England, the
Netherlands, Germany and France.
The Company's One Zero Media subsidiary ("OZM") is located in approximately
22,000 square feet of space under three leases expiring in June 2000 and April,
2003.
The Company maintains several facilities in London, England totaling
approximately 16,000 square feet, from which it conducts a substantial portion
of its European operations, under leases that expire in the years 2000 and 2020.
Additional facilities for sales, marketing and operations are located in Paris
and Hamburg. One of the London facilities is owned by Marylebone 248 Realty LLC,
an affiliate of Joseph J. Cayre. The Company believes that the terms of this
lease are no less favorable to the Company than those it could obtain from
independent third parties.
The Company also maintains approximately 4,700 square feet of office space
in Australia under leases which expire in September 1999 and November 2000.
ITEM 3. LEGAL PROCEEDINGS
On September 18, 1997, Scavenger, Inc., a software developer, filed a
lawsuit against the Company in New York Supreme Court claiming that the Company
breached a software development contract between the parties dated November 28,
1995. Scavenger alleges that the Company, after paying $2.5 million in advances
and accepting delivery of gold master disks for two computer games, refused to
pay any more advances, including advances relating to the development of two
additional games under the agreement. Scavenger is suing for the remaining
advances ($4.3 million) and for future royalties ($5 million), and also seeks
consequential damages for allegedly being forced out of business ($100 million)
and losing contracts with unspecified third parties ($4 million) as a result of
the Company's alleged breach. The Company filed an answer and counterclaim, in
which it denies any liability to Scavenger and alleges, among other things, that
the contract was lawfully terminated when Scavenger failed to deliver the two
remaining games after receiving from the Company written notice to cure its
material breaches. By its counterclaim, the Company seeks damages and
restitution for at least $5 million on grounds of breach of contract and unjust
enrichment.
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Pursuant to a preliminary conference order dated February 11, 1998, the parties
had until year end 1998 to conduct discovery. On September 17, 1998, however,
Scavenger's counsel filed a motion seeking to be relieved as counsel, which the
Court granted on October 6, 1998. At a November 12, 1998 preliminary conference,
another attorney appeared as Scavenger's prospective new counsel, subject to
further discussions with Scavenger. New counsel thereafter filed a notice of
appearance in the case. At a December 1, 1998 compliance conference, the Court
reissued a discovery order, whereby discovery must be completed by July 30,
1999. Another compliance conference has been scheduled for June 30, 1999.
Scavenger has now moved for partial summary judgment on its first two causes of
action for remaining advances ($4.3 million), and the Company has opposed that
motion and asked the court to dismiss those two claims with prejudice. The
Company intends to vigorously defend this action and pursue its counterclaim.
In January, February, and March 1998, ten substantially similar complaints
were filed against the Company, its former Chairman and its former Chief
Executive Officer, and in certain actions, its former Chief Financial Officer,
in the United States District Court for the Southern District of New York. The
plaintiffs, in general, purport to sue on behalf of a class of persons who
purchased shares (and as to certain complaints, purchased call options or sold
put options) of the Company during the period from August 1, 1996 through
December 12, 1997. The plaintiffs allege that the Company violated the federal
securities laws by making misrepresentations and omissions of material facts
that allegedly artificially inflated the market price of the Company's common
stock during the class period. The plaintiffs further allege that the Company
failed to expense properly certain prepaid royalties for software products that
had been terminated or had failed to achieve technological feasibility, which
misstatements purportedly had the effect of overstating the Company's net income
and net assets. Motions were made by certain groups of plaintiffs for their
appointment as lead plaintiffs in the actions. On October 7, 1998, the Court
appointed lead plaintiffs and lead counsel to the plaintiffs in the actions. The
plaintiffs' consolidated and amended complaint was filed and served in early
January 1999. By order dated January 23, 1999, the plaintiffs were granted leave
to file a second consolidated and amended complaint, which added claims under
Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 against the
Company's independent auditor, Arthur Andersen LLP. The Company and Arthur
Andersen LLP have each filed motions to dismiss the second consolidated and
amended complaint. The Company believes that these complaints are without merit
and intends to defend itself vigorously against these actions.
On January 25, 1999, the Company filed a complaint in the Supreme Court of
the State of New York, County of New York, against Midway Games, Inc. ("Midway
Games"), Midway Home Entertainment, Inc. ("Midway Home"), Midway Manufacturing
Company, WMS Industries, Inc. ("WMS"), Williams Electronics Games, Inc.,
Williams Entertainment Inc., Williams Interactive, Inc. and Atari Games
Corporation (collectively the "Midway Defendants") seeking injunctive relief and
tens of millions of dollars in damages arising out of the Midway Defendants'
breach of certain agreements that give the Company an exclusive option to
distribute, in territories throughout the world, entertainment software products
acquired or developed by the Midway Defendants for personal computers and video
console systems. On February 24, 1999, the Midway Defendants moved to dismiss
the action in its entirety. On May 21, 1999, the Court denied the motion as to
the Company's claims for breach of contract, breach of the implied covenant of
good faith and fair dealing and injunctive relief. The Court granted the motion
as to defendant Williams Interactive, Inc., and also dismissed the Company's
claims for tortious interference with prospective business relations,
anticipatory repudiation and defamation. On May 28, 1999, the Midway Defendants
answered the complaint and asserted counterclaims against the Company for breach
of contract and violations of the Illinois Consumer Fraud and Deceptive Business
Practices Act. The Company intends to vigorously defend these counterclaims.
On May 28, 1999, Midway Games also sent notice that it was terminating the
Company's rights under the GTIS Master Option and License Agreements but not the
individual Distribution and License Agreements now in effect. On June 1, 1999,
the Company moved for a preliminary injunction to enjoin the Midway Defendants
from terminating the Company's option rights. On June 8, 1999, the Court denied
the Company's request for a preliminary injunction. The Company will continue to
litigate this matter.
In June 1999, the Company received notice that Midway Home, a subsidiary of
Midway Games Inc., had filed an action against the Company in the District Court
of Navarro County, Texas. During 1994 and 1995,
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WMS received warrants to purchase 214,285 shares of the Company's common stock
at an exercise price equal to the price at which shares were to be sold in the
Company's initial public offering in December 1995. These warrants were issued
in connection with the license agreements that the Company and WMS (and certain
affiliates) entered into in 1994 and 1995 ("License Agreements"). According to
the petition, WMS assigned these warrants to Midway Home on October 23, 1996.
Plaintiff alleges that on that day, Midway Home exercised 71,428 of the warrants
for a total consideration of $1,000,000, promptly sold 46,675 of the shares at
the then market price of $21.425, and continues to hold 24,754 of the shares. As
in the federal securities class actions described above, Midway Home contends
that the Company failed to expense properly certain prepaid royalties for
software products, which misstatements purportedly had the effect overstating
the Company's net profits. It asserts claims under the Texas Securities Act and
the Texas Business and Commerce Code and for common law fraud, negligent
misrepresentation and breach of contract. Midway Home seeks damages, rescission
of its purchase of 24,754 shares of the Company's stock, reformation of the
warrants to include a strike price below $14.00 per share (the initial public
offering price of the Company's common stock in December 1995) and to increase
the number of warrants that should allegedly have been issued to WMS, as well as
exemplary damages, attorneys fees, interest and other costs. The Company intends
to vigorously defend itself against these claims.
On April 12, 1999, an action was commenced by the administrators for three
children who were murdered on December 1, 1997 by Michael Carneal at the Heath
High School in McCracken County, Kentucky. The action was brought against 25
defendants, including the Company and other corporations in the videogame
business; companies that produced or distributed the movie "The Basketball
Diaries;" and companies that allegedly provide obscene internet content. The
complaint alleges, with respect to the Company and other videogame corporations,
that Carneal was influenced by the allegedly violent content of certain
videogames and that the videogame manufacturers are liable for Carneal's
conduct. The complaint seeks $10 million in compensatory damages and $100
million in punitive damages. The Company and approximately 10 other videogame
corporations have entered into a joint defense agreement, and have retained
counsel. The Court has stayed all discovery pending an initial case management
conference scheduled for July 19, 1999. The Company intends to vigorously defend
this action.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
On January 8, 1999, stockholders holding 42,801,556 shares of Common Stock,
representing approximately 59% of the outstanding shares of the Company's Common
Stock, executed and delivered a Written Consent of the Stockholders in Lieu of a
Special Meeting (the "Written Consent") approving and adopting an amendment to
the Company's 1997 Stock Incentive Plan to increase, from 1,000,000 to
3,000,000, the total number of shares of Common Stock with respect to which
options may be granted to any one employee of the Company during any one-year
period. On March 1, 1999, the Company filed an Information Statement on Schedule
14C (the "Information Statement") pursuant to the requirements of Rule 14c-2
promulgated under Section 13 of the Securities Exchange Act of 1934, as amended,
to inform holders of Common Stock entitled to vote or give an authorization or
consent in regard to the action authorized by the Written Consent, of the action
so taken. The Information Statement is filed as an exhibit to this Annual Report
and the contents of the Information Statement are incorporated by reference into
this Annual Report.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is quoted on the Nasdaq National Market. The
high and low sale prices for the Common Stock as reported by the Nasdaq National
Market for the years ended December 31, 1996 and 1997, the three month
transition period ended March 31, 1998 and for the fiscal year ended March 31,
1999 are summarized below. These over-the-counter market quotations reflect
inter-dealer prices, without retail mark-ups, mark-downs, or commissions and may
not necessarily represent actual transactions.
HIGH LOW
--------- ---------
1996
First Quarter............................................... $15 $ 8 7/8
Second Quarter.............................................. $25 $10 5/8
Third Quarter............................................... $26 3/4 $16 3/4
Fourth Quarter.............................................. $26 3/4 $ 6 5/8
1997
First Quarter............................................... $ 9 1/4 $ 7 1/8
Second Quarter.............................................. $11 7/8 $ 5 7/8
Third Quarter............................................... $12 3/4 $ 9
Fourth Quarter.............................................. $12 3/8 $ 6 1/8
1998
Three Month Transition Period............................... $ 8 9/16 $ 5 5/16
FISCAL 1999
First Quarter............................................... $11 1/8 $ 7
Second Quarter.............................................. $ 9 $ 4 1/2
Third Quarter............................................... $ 7 7/16 $ 3 3/4
Fourth Quarter.............................................. $ 5 13/16 $ 3 7/8
On June 18, 1999, the last reported sale price of the Common Stock on the
Nasdaq National Market was $3 7/8. As of June 18, 1999, there were approximately
256 registered holders of record of the Common Stock.
The Company currently anticipates that it will retain all of its future
earnings for use in the expansion and operation of its business and does not
anticipate paying any cash dividends on its Common Stock in the foreseeable
future. In addition, the payment of cash dividends is limited by the New Credit
Agreement and may be limited by financing agreements entered into by the Company
in the future.
RECENT SALES OF UNREGISTERED SECURITIES
On February 23, 1999, the Company issued to certain affiliates of General
Atlantic 600,000 shares of its Series A Convertible Preferred Stock, par value
$0.01 per share (the "Series A Preferred Stock"), for an aggregate purchase
price of $30 million. Each share of Series A Preferred Stock is convertible at
any time into ten shares of the Company's Common Stock, and will vote on an
as-converted basis with the Common Stock as a single class. The securities
issued in this transaction were not registered under the Securities Act of 1933,
as amended, pursuant to the exemption provided under Section 4(2) thereof for
transactions not involving a public offering.
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ITEM 6. SELECTED FINANCIAL DATA
The following tables set forth selected consolidated financial information
of the Company which, for each of the years in the four year period ended
December 31, 1997, the three months ended March 31, 1998 and the year ended
March 31, 1999, is derived from the audited consolidated financial statements of
the Company. Consolidated financial information for the three months ended March
31, 1997 and the twelve months ended March 31, 1998 is unaudited. These tables
should be read in conjunction with the Company's Consolidated Financial
Statements, including the notes thereto, appearing elsewhere in this Annual
Report on Form 10-K. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
THREE MONTHS YEARS ENDED
YEARS ENDED DECEMBER 31, ENDED MARCH 31, MARCH 31,
----------------------------------------- ------------------ -------------------
1994 1995 1996 1997 1997 1998 1998 1999
-------- -------- -------- -------- ------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
STATEMENT OF OPERATIONS DATA:
Net revenues.......................... $101,826 $234,461 $365,490 $530,677 $93,381 $105,767 $543,063 $572,342
Cost of goods sold.................... 54,449 138,662 214,580 315,134 57,883 57,092 314,343 329,959
Selling and distribution expenses..... 16,104 41,733 72,517 98,689 16,538 24,467 106,618 147,499
General and administrative expenses... 10,539 19,491 31,157 45,561 8,623 10,655 47,593 66,616
Research and development.............. -- 1,717 5,633 13,824 2,397 10,866 22,293 76,870
Royalty advance write-off............. -- -- -- 73,821 -- -- 73,821 --
Restructuring charges................. -- -- -- -- -- -- -- 17,479
Purchased research and development.... -- -- -- 11,008 -- -- 11,008 5,000
SingleTrac retention bonus............ -- -- -- 2,400 -- -- 2,400 1,680
Merger and other costs................ -- -- 3,718 1,050 -- -- 1,050 --
Amortization of goodwill.............. -- 567 1,092 1,295 347 636 1,584 3,349
-------- -------- -------- -------- ------- -------- -------- --------
Operating income (loss)............... 20,734 32,291 36,793 (32,105) 7,593 2,051 (37,647) (76,110)
Interest and other income (expense),
net................................. 41 795 3,974 (2,075) 247 (1,389) (3,711) (5,315)
-------- -------- -------- -------- ------- -------- -------- --------
Income (loss) before provision for
(benefit from) income taxes......... 20,775 33,086 40,767 (34,180) 7,840 662 (41,358) (81,425)
Provision for (benefit from) income
taxes:
Federal and state (historical)...... 2,427 14,002 15,628 (9,157) 3,386 304 (12,239) (29,628)
Benefit from change in tax
status(1)......................... -- (3,520) -- -- -- -- -- --
-------- -------- -------- -------- ------- -------- -------- --------
Total provision for (benefit
from) income taxes......... 2,427 10,482 15,628 (9,157) 3,386 304 (12,239) (29,628)
-------- -------- -------- -------- ------- -------- -------- --------
Net income (loss) from continuing
operations.......................... 18,348 22,604 25,139 (25,023) 4,454 358 (29,119) (51,797)
Discontinued operations:
Loss from operations of OZM......... -- -- -- -- -- -- -- (3,531)
Loss on disposal of OZM............. -- -- -- -- -- -- -- (15,510)
-------- -------- -------- -------- ------- -------- -------- --------
Loss from discontinued operations... -- -- -- -- -- -- -- (19,041)
-------- -------- -------- -------- ------- -------- -------- --------
Net income (loss) before dividends
on preferred stock................ 18,348 22,604 25,139 (25,023) 4,454 358 (29,119) (70,838)
Less dividends on preferred stock..... -- -- -- -- -- -- -- 226
-------- -------- -------- -------- ------- -------- -------- --------
Net income (loss) attributable to
common stockholders................. $ 18,348 $ 22,604 $ 25,139 $(25,023) $ 4,454 $ 358 $(29,119) $(71,064)
======== ======== ======== ======== ======= ======== ======== ========
Basic net income (loss) per share from
continuing operations............... $ 0.38 $ (0.37) $ 0.07 $ 0.01 $ (0.43) $ (0.75)
Basic net loss per share from
discontinued operations............. -- -- -- -- -- $ (0.27)
-------- -------- ------- -------- -------- --------
Basic net income (loss) per share..... $ 0.38 $ (0.37) $ 0.07 $ 0.01 $ (0.43) $ (1.02)
======== ======== ======= ======== ======== ========
Weighted average shares outstanding... 66,391 66,982 66,395 67,938 67,363 69,654
======== ======== ======= ======== ======== ========
Diluted net income (loss) per share
from continuing operations.......... $ 0.37 $ (0.37) $ 0.07 $ 0.01 $ (0.43) $ (0.75)
Diluted net loss per share from
discontinued operations............. -- -- -- -- -- $ (0.27)
-------- -------- ------- -------- -------- --------
Diluted net income (loss) per share... $ 0.37 $ (0.37) $ 0.07 $ 0.01 $ (0.43) $ (1.02)
======== ======== ======= ======== ======== ========
Weighted average shares outstanding... 68,313 66,982 67,358 68,384 67,363 69,654
======== ======== ======= ======== ======== ========
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DECEMBER 31, MARCH 31,
---------------------------------------- -------------------
1994 1995 1996 1997 1998 1999
------- -------- -------- -------- -------- --------
BALANCE SHEET DATA:
Cash and cash equivalents and short-term investments..... $ 4,496 $ 93,694 $ 76,584 $ 39,713 $ 17,329 $ 13,512
Working capital (deficit)................................ (4,180) 105,748 113,652 77,965 69,994 131,770
Total assets............................................. 72,332 301,641 367,111 457,725 365,871 487,615
Total debt............................................... 413 868 1,415 54,619 28,017 98,750
Stockholders' equity (deficit)........................... (3,637) 126,040 152,138 134,241 138,889 127,133
- ---------------
(1) The benefit from change in tax status occurred as a result of the transition
from an S corporation to a C corporation on March 1, 1995, which allowed the
Company to accrue certain tax benefits which would otherwise have flowed to
the stockholders of the S corporation. This benefit would not have arisen
for the year ended December 31, 1995 had the Company been a C corporation
beginning January 1, 1994.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company develops, publishes, and distributes interactive entertainment
for the children's education ("edutainment"), leisure entertainment, and gaming
enthusiast's markets for a variety of platforms. The Company employs a portfolio
approach to achieve a broad base of published products across most major
consumer software categories. Since it commenced operations in February 1993,
the Company has experienced rapid growth and its product and customer mix has
changed substantially.
Publishing and distribution are the two major activities of the Company.
Publishing is divided into Front-line, Leisure and Children's publishing.
Because each of these product categories has different associated costs, the
Company's margins have depended and will depend, in part, on the percentage of
net revenues attributable to each category. In addition, a particular product's
margin may depend on whether it has been internally or externally developed and
on what platforms it is published. Further, the Company's margins may vary
significantly from quarter to quarter depending on the timing of its new
published product releases. To the extent that mass merchants require greater
proportions of third-party software products, some of which may yield lower
margins, the Company's operating results may be impacted accordingly.
The worldwide interactive entertainment software market is comprised
primarily of software for two distinct platforms: PCs and dedicated game
consoles. The market has grown dramatically in recent years with its growth
driven by the increasing installed base of multimedia PCs and current generation
game console systems. In addition, the development of enabling multimedia
technologies, the proliferation of software titles, the development of new and
expanding distribution channels and the emergence of a strong international
market for interactive entertainment software have spurred the rapid expansion
of the interactive entertainment market.
The Company develops and publishes products for multiple platforms, and
this diversification continues to be a cornerstone of the Company's strategy.
Sales of the Company's PlayStation, N64, Sega Saturn and Gameboy titles
("Console Titles") increased from 10% of the Company's front-line revenue during
the year ended December 31, 1996 ("1996") to 58% in the year ended December 31,
1997 ("1997"), 62% in the three months ended March 31, 1998 ("1998") and 64% in
the twelve months ended March 31, 1999 ("fiscal 1999"). Since 1996, the Company
has released approximately 50 Console Titles. As evidenced by the strong sales
of these platforms, the Company believes that significant growth opportunities
exist across a variety of next generation hardware platforms, in particular
PlayStation, for which the Company continues to create software products.
There has been an increased rate of change and complexity in the
technological innovations affecting the Company's products, coupled with
increased competitiveness for shelf space and buyer selectivity. The market for
Frontline titles has become increasingly hit-driven, which has led to higher
production budgets, more complex development processes, longer development
cycles and generally shorter product life cycles. The importance of the timely
release of hit titles, as well as the increased scope and complexity of the
product development and production process, have increased the need for
disciplined product development processes that limit cost and schedule overruns.
This in turn has increased the importance of leveraging the technologies,
characters or story-lines of such hit titles into additional interactive
entertainment software products in order to spread development costs among
multiple products. In this environment, the Company is determined to achieve a
balance between development done by its own internal development studies and
that done by third-party developers.
Along with its industry competitors, the Company had historically
capitalized royalties advanced to third-party developers as a prepayment in
current assets and evaluated the realization of these royalty advances on a
quarterly basis. The market changes noted above have made it extremely difficult
to determine the likelihood of individual product acceptance and success. As a
result, in the quarter ended December 31, 1997, the Company expensed royalty
advances of $73.8 million on products that were in development or on sale. In
connection with this change in the dynamics of the marketplace, the Company
changed its accounting,
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beginning on January 1, 1998, for future royalty advances, treating such costs
as research and development expenses, which are expensed as incurred. Multi-year
output advances will continue to be capitalized as royalty advances and expensed
over the development periods, in accordance with generally accepted accounting
principles.
The distribution channels for interactive software have changed
significantly in recent years. Traditionally, consumer software was sold through
specialty stores. Today, consumer software is increasingly sold through mass
merchants such as Wal-Mart, Kmart and Target, as well as major retailers,
including Office Depot, Best Buy, CompUSA, AAFES, Sam's Club and Babbage's. The
Internet and on-line networks also present a new channel through which
publishers and distributors can distribute their products to end-users.
In 1996, the Company acquired WizardWorks, a publisher of value-priced
interactive entertainment, edutainment and productivity software, FormGen Inc.,
a publisher of interactive PC shareware and software and Humongous, a premier
developer and publisher of original interactive children's software.
WizardWorks, FormGen and Humongous (collectively the "Acquired Companies"), have
each been accounted for as a pooling of interests. Accordingly, the Company's
historical Consolidated Financial Statements have been restated to include the
results of the Acquired Companies.
In 1996, the Company acquired the business of Warner Interactive Europe, a
developer and publisher of interactive PC software. In 1997, the Company
acquired Premier Promotion Limited, the parent company of One Stop, a leading
European value software distributor and publisher and SingleTrac, a leading
developer of frontline software. In 1998, the Company acquired OZM, an Internet
entertainment company, Reflections and Legend, developers of entertainment
software, and Home Soft Benelux B.V. ("Homesoft"), a distributor of
entertainment software. Financial results of these companies have been included
in the Company's Consolidated Financial Statements on a purchase basis for the
period since the acquisition. At March 31, 1999, OZM is accounted for as a
discontinued operation and it is the Company's present intention to sell OZM.
Except for OZM, these acquisitions did not have a material impact on the
financial condition or the results of operations of the Company in the year
acquired.
Sales are recorded net of expected future returns. Historically, the
Company has experienced returns at approximately 30% of gross sales.
Effective January 1, 1998, the Company changed its fiscal year from
December 31 to March 31. Accordingly, the discussion of financial results set
forth below compares the twelve months ended March 31, 1999 to the twelve months
ended March 31, 1998, the three months ended March 31, 1998 to the comparable
1997 period, and compares the Company's previous fiscal years ended December 31,
1997, 1996 and 1995.
The consumer software industry is seasonal. Net revenues are typically
highest during the fourth calendar quarter. This seasonality is primarily a
result of the increased demand for consumer software during the year-end holiday
buying season.
RESULTS OF OPERATIONS
The following table sets forth certain consolidated statements of
operations data as a percentage of net revenues for each of the years in the
three years ended December 31, 1997, the three months ended March 31, 1998 and
the twelve months ended March 31, 1999, that is derived from the audited
consolidated financial statements of the Company. The consolidated financial
information for the three months ended March 31,
23
25
1997 and the twelve months ended March 31, 1998 is derived from the unaudited
financial statements of the Company.
THREE MONTHS
ENDED YEAR ENDED
YEARS ENDED DECEMBER 31, MARCH 31, MARCH 31,
-------------------------- -------------- --------------
1995 1996 1997 1997 1998 1998 1999
------ ------ ------ ----- ----- ----- -----
Net revenues................................ 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of goods sold.......................... 59.1 58.7 59.4 62.0 54.0 57.9 57.7
Selling and distribution expenses........... 17.9 19.9 18.6 17.7 23.1 19.6 25.8
General and administrative expenses......... 8.3 8.5 8.6 9.2 10.1 8.8 11.6
Research and development.................... 0.7 1.5 2.6 2.6 10.3 4.1 13.4
Royalty advance write-off................... -- -- 13.9 -- -- 13.6 --
Restructuring charges....................... -- -- -- -- -- -- 3.1
Purchased research and development.......... -- -- 2.1 -- -- 2.0 0.9
SingleTrac retention bonus.................. -- -- 0.4 -- -- 0.4 0.3
Merger and other costs...................... -- 1.0 0.2 -- -- 0.2 --
Amortization of goodwill.................... 0.2 0.3 0.2 0.4 0.6 0.3 0.6
----- ----- ----- ----- ----- ----- -----
Operating income (loss)..................... 13.8 10.1 (6.0) 8.1 1.9 (6.9) (13.3)
Interest and other income (expense), net.... 0.3 1.1 (0.4) 0.3 (1.3) (0.7) (0.9)
----- ----- ----- ----- ----- ----- -----
Income (loss) before provision for (benefit
from) income taxes........................ 14.1 11.2 (6.4) 8.4 0.6 (7.6) (14.2)
Provision for (benefit from) income taxes... 4.5 4.3 (1.7) 3.6 0.3 (2.3) (5.2)
----- ----- ----- ----- ----- ----- -----
Net income (loss) from continuing
operations................................ 9.6 6.9 (4.7) 4.8 0.3 (5.4) (9.1)
Discontinued operations:
Loss from operations of OZM............... -- -- -- -- -- -- (0.6)
Loss on disposal of OZM................... -- -- -- -- -- -- (2.7)
----- ----- ----- ----- ----- ----- -----
Loss from discontinued operations......... -- -- -- -- -- -- (3.3)
----- ----- ----- ----- ----- ----- -----
Net income (loss) before dividends on
preferred stock......................... 9.6 6.9 (4.7) 4.8 0.3 (5.4) (12.4)
Less dividends on preferred stock........... -- -- -- -- -- -- --
----- ----- ----- ----- ----- ----- -----
Net income (loss) attributable to common
stockholders.............................. 9.6% 6.9% (4.7)% 4.8% 0.3% (5.4)% (12.4)%
===== ===== ===== ===== ===== ===== =====
Twelve Months Ended March 31, 1999 Compared to Twelve Months Ended March 31,
1998
Net revenues for fiscal 1999 increased approximately $29.3 million, or
5.4%, to $572.3 million from $543.1 million in fiscal 1998. This growth in net
revenues was attributable to increases in net revenues of Children's publishing,
Leisure publishing and Distribution of $23.2 million, or 108%, $12.5 million, or
39%, and $12.3 million, or 5%, respectively. The increase in Children's net
revenue is attributable to the release of Blue's Clues related titles during
fiscal 1999. The increase in Leisure's net revenue is attributable to the
increased and continuing success of Deer Hunter, Deer Hunter II and Rocky
Mountain Trophy Hunter. The increase in Distribution net revenues for fiscal
1999 is primarily due to an increase in the number of stores supplied and
serviced by the Company.
These increases are offset by a reduction in Frontline net revenue of 18.7
million, or 8%. The decrease is largely attributable to a $13.5 million, or 71%
decrease in royalty income.
Cost of goods sold for fiscal 1999 increased approximately $15.6 million,
or 5.0%, to $330.0 million from $314.3 million in fiscal 1998. Cost of goods
sold as a percentage of net revenues decreased to 57.7% in fiscal 1999 as
compared to 57.9% in fiscal 1998. Excluding increased charges for obsolete
inventory between the periods, the cost of goods percentage would have been
55.4% of net revenue in fiscal 1999. This decrease is primarily a result of
increased sales in the Children's and Leisure categories of publishing.
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Selling and distribution expenses primarily include shipping expenses,
sales and distribution labor expenses, advertising and promotion expenses and
distribution facilities costs. During fiscal 1999, these expenses increased
approximately $40.9 million, or 38.3%, to $147.5 million from $106.7 million in
fiscal 1998. Selling and distribution expenses as a percentage of net revenues
for fiscal 1999 increased to 25.8% as compared to 19.6% in fiscal 1998. The
increase, as a percentage of net revenues, was primarily attributable to the
increase of print advertising worldwide to support the new and existing releases
of the Company's published product and increased cooperative advertising.
Additionally, increased premium freight costs due to higher unit volume and the
expense of consolidating inventory of the Company's Plymouth, MN distribution
center into its Edison, NJ distribution center, as compared to fiscal 1998. The
overall increase was also attributable to increased sales volume.
General and administrative expenses primarily include personnel expenses,
facilities costs, professional expenses and other overhead charges. These
expenses in fiscal 1999 increased approximately $19.0 million, or 40%, to $66.6
million from $47.6 million in fiscal 1998. General and administrative expenses
as a percentage of net revenues increased to 11.6% in fiscal 1999 from 8.8% in
fiscal 1998. This increase was due primarily to increased depreciation
associated with the expansion of the Company's worldwide facilities and the
implementation of enterprise software to enhance the Company's management
information systems worldwide, the increase in bad debt expenses, additional
legal and accounting fees incurred as part of the discontinued private placement
of senior subordinated debt and the write-off of an equity investment.
Research and development primarily includes payment for royalty advances to
third party developers on products that are currently in development and direct
costs of internally developing and producing a title such as salaries and other
related costs. These expenses in fiscal 1999 increased approximately $54.6
million, or 244.8%, to $76.9 million from $22.3 million in fiscal 1998. Research
and development, as a percentage of net revenues, increased to 13.4% in fiscal
1999 from 4.1% in fiscal 1998. This increase is primarily due to the change in
accounting effective January 1, 1998, whereby royalty advances on products that
are currently in development are expensed as incurred, and the additional
headcount attributable to increased in-house development capacity. Research and
development of the Company's internal development studios, which, during the
relevant periods, primarily included SingleTrac, Cavedog Entertainment,
Humongous, Legend Entertainment, Reflections and Bootprint increased to $34.9
from $17.6 million in fiscal 1999 as compared to fiscal 1998. Excluding the
impact of the change in accounting, research and development expenses would have
increased $28.2 million from $48.7 million to $76.9 million or 58%.
Restructuring charges of approximately $17.5 million, recorded in the
fourth quarter of fiscal 1999, relate to a reorganization of the Company's
Frontline publishing business, contemplated relocation of corporate headquarters
to California and outsourcing of the Company's distribution function.
Approximately $9.8 million relates to the planned severance of 135 employees,
$7.1 million relates to impaired assets and $0.6 million relates to rent for the
transition period. This reorganization was announced on March 19, 1999, and
management expects to complete the reorganization by March 19, 2000.
The charge for royalty advance write-off of $73.8 million during fiscal
1998 represents a change in estimate and accounting whereby royalty advances on
products that were currently in development or on sale were expensed. In
connection with this change, the Company prospectively expensed royalty advances
in a manner comparable with internal software development costs, which are
expensed to research and development as incurred.
In connection with the acquisitions of SingleTrac in October 1997 and
Reflections in December 1998, the Company incurred charges of $11.0 million and
$5.0 million, respectively, for purchased research and development. In addition,
the Company incurred a charge of $2.4 million and $1.7 million in fiscal 1998
and fiscal 1999, respectively, for a retention bonus for the SingleTrac
employees, which was based on the achievement of certain performance goals.
Merger costs consist of legal, accounting and other professional fees
incurred by the Company for the canceled acquisition of MicroProse, Inc., during
fiscal 1998.
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Amortization of goodwill increased approximately $1.8 million, or 111.4% in
fiscal 1999, to $3.3 million from $1.6 million in fiscal 1998. This increase is
attributable to the purchases of Reflections, Homesoft, Prism and Legend in
fiscal 1999.
Interest and other expenses increased approximately $1.6 million during
fiscal 1999 to $5.3 million from $3.7 million in fiscal 1998. This increase was
primarily attributable to the increase in interest costs associated with
borrowings under the Revolving Credit Agreement (the "Credit Agreement").
The Company's effective tax rate for fiscal 1999 was 36% compared to 30% in
fiscal 1998. The increased rate is attributable to the lower proportion of
nondeductible expenses, primarily purchased research and development and
goodwill, in the current period.
In February 1999, certain partnerships affiliated with General Atlantic
purchased from the Company 0.6 million shares of the Company's Series A
convertible preferred stock ("Preferred Stock") for an aggregate purchase price
of $30.0 million. These shares of Preferred Stock accumulate dividends at 8.0%
and are convertible into 6.0 million shares of the Company's common stock at a
conversion price of $5 per share.
Pursuant to Accounting Principles Board Opinion No. 30 "Reporting the
Results of Operations -- Reporting Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions" ("APB 30"), the Consolidated Financial Statements of the Company
reflect the planned disposal of OZM as a discontinued operation. Accordingly,
the revenues, costs and expenses, assets and liabilities, and cash flows of this
business have been excluded from the respective captions in the Consolidated
Balance Sheets, Consolidated Statements of Operations, Consolidated Statements
of Comprehensive Income and Consolidated Statements of Cash Flows, and have been
reported through its planned date of disposition as "Loss from discontinued
operations." As of March 31, 1999, OZM is accounted for as a discontinued
operation and it is the Company's present intention to sell OZM, resulting in an
anticipated loss from discontinued operations of $19.0 million. The loss from
operations of OZM represents net expenses of $4.6 million on net revenues of
$1.1 million. The loss on disposal of OZM includes a provision of $5.0 million
for operating losses during the phase-out period, and is primarily attributable
to the write-off of goodwill of approximately $18.3 million. There is no tax
benefit recorded on the loss from discontinued operations as OZM has
historically generated net losses.
Three Months Ended March 31, 1998 Compared to Three Months Ended March 31,
1997
Net revenues for 1998 increased approximately $12.4 million, or 13.3%, to
$105.8 million from $93.4 million in the comparable 1997 period. This growth in
net revenues was primarily attributable to a 49% increase in publishing revenue
which includes front-line, children's and leisure. Frontline net revenue
increased $9.4 million, or 36% from $26.4 million to $35.9 million, as a result
of the sales of Duke Nukem titles for the Playstation, N64 and the PC, Hexen for
N64, OddWorld: Abe's Oddysee for the Playstation, Total Annihilation for the PC,
East Meets West, and Quake N64, internationally. Leisure publishing's net
revenue increased $4.1 million, or 103% as a result of continued strong sales of
Deer Hunter and Wild Turkey Hunt for the PC. Children's net revenue increased
$2.6 million or 120% as a result of newly released titles such as Freddi Fish 3:
The Case of the Stolen Conch Shell. The overall increase in net revenues was
partially offset by the decrease in distribution net revenues to $57.1 million,
or 54% of net revenues, in 1998 from $60.8 million, or 65% of net revenues, in
the comparable 1997 period, as a result of Wal-Mart purchasing software directly
from several publishers whose software was previously sold to Wal-Mart by the
Company.
Cost of goods sold primarily includes costs of purchased products. Cost of
goods sold for 1998 decreased approximately $0.8 million, or 1.4%, to $57.1
million from $57.9 million in the comparable 1997 period. Cost of goods sold as
a percentage of net revenues decreased to 54.0% in 1998 as compared to 62.0% in
the comparable 1997 period. The decrease, as a percentage of net revenues, was
primarily due to the Company's change in accounting with respect to royalty
advances, resulting in the expensing of such advances to research and
development as incurred, rather than recouping such advances based on sales.
Additionally, the Company's overall sales mix of its Published Product, which
generally have higher margins, increased to 46% of net revenues in 1998 compared
to 35% in the comparable 1997 period. This decrease was partially offset by
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the higher sales of console titles, which generally have higher costs than PC
titles. Console titles accounted for 45% of Published Product revenue in 1998
compared to 17% during the comparable 1997 period.
Selling and distribution expenses primarily include shipping expenses,
sales and distribution labor expenses, advertising and promotion expenses and
distribution facilities costs. During 1998 these expenses increased
approximately $7.9 million, or 47.9%, to $24.5 million from $16.5 million in the
comparable 1997 period. Selling and distribution expenses as a percentage of net
revenues for 1998 increased to 23.1% as compared to 17.7% in the comparable 1997
period. The increase, as a percentage of net revenues, was primarily
attributable to the increase of print advertising worldwide to support the new
and existing releases of the Company's Published Product and increased
cooperative advertising associated with higher published front-line revenues as
compared to the comparable 1997 period. The overall increase was also
attributable to increased sales volume.
General and administrative expenses primarily include personnel expenses,
facilities costs, professional expenses and other overhead charges. These
expenses in 1998 increased approximately $2.0 million, or 23.6%, to $10.7
million from $8.6 million in the comparable 1997 period. General and
administrative expenses as a percentage of net revenues increased to 10.1% in
1998 from 9.2% in the comparable 1997 period. This increase was due primarily to
additional personnel required to support the expansion of the Company's
publishing operations and the related amortization associated with the expansion
of the Company's worldwide facilities and the implementation of enterprise
software to enhance the Company's management information systems worldwide.
Research and development expenses primarily include payment for royalty
advances to third party developers on products that are currently in development
and direct costs of internally developing and producing a title such as salaries
and other related costs. These expenses in 1998 increased approximately $8.5
million, or 353.3%, to $10.9 million from $2.4 million in the comparable 1997
period. Research and development expenses as a percentage of net revenues
increased to 10.3% in 1998 from 2.6% in the comparable 1997 period. This
increase is primarily due to the change in accounting effective for the three
months ended March 31, 1998, whereby royalty advances on products that are
currently in development or on sale are expensed as incurred, and the additional
headcount attributable to increased in-house development capacity primarily the
result of the SingleTrac acquisition.
Interest and other income (expense), net, decreased approximately $1.6
million during 1998 to an expense of $1.4 million from income of $0.2 million in
the comparable 1997 period. This decrease was primarily attributable to the
decrease in short-term investments and the increase in interest costs associated
with borrowings under the Revolving Credit Agreement (the "Credit Agreement").
The Company's effective tax rate for 1998 was 46% compared to 43% in the
comparable 1997 period. The increase is attributable to the higher proportion of
nondeductible expenses, primarily goodwill, in the current period.
Twelve Months Ended December 31