UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

   (Mark One)

For the quarterly period ended April 3, 2004

or

For the transition period from ____________ to ____________.

Commission File Number: 0-26976

Pixar

(510) 752-3000
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (the “Act”) during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [  ].

     The number of shares outstanding of the Registrant’s Common Stock as of May 5, 2004 was 56,227,655.

Pixar
FORM 10-Q
Index

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

PIXAR

BALANCE SHEETS

(Unaudited, in thousands, except share data)

See accompanying notes to financial statements.

2

PIXAR

STATEMENTS OF INCOME

(Unaudited, in thousands, except per share data)

See accompanying notes to financial statements.

3

PIXAR

STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

See accompanying notes to financial statements.

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PIXAR

NOTES TO FINANCIAL STATEMENTS

(1) Basis of Presentation

     The accompanying unaudited condensed financial statements have been prepared in conformity with U.S. generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation of the financial condition, results of operations, and cash flows of Pixar (or the “Company”) for the periods presented. These financial statements should be read in conjunction with the audited financial statements as of January 3, 2004 and for each of the years in the three-year period ended January 3, 2004, including notes thereto. These audited financial statements are included in Pixar’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 18, 2004.

     The results of operations for the quarter ended April 3, 2004 are not necessarily indicative of the results expected for the current year or any other period.

     Certain amounts reported in previous periods have been reclassified to conform to the 2004 financial statement presentation.

(2) Fiscal Year

     Pixar operates on a 52 or 53-week fiscal year, whereby the year ends on the Saturday nearest December 31. Fiscal 2004 will end on January 1, 2005 and will consist of 52 weeks.

(3) Stock Option Accounting

     The Company has elected to continue using the intrinsic-value method of accounting for stock-based compensation plans in accordance with Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company has adopted those provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which require disclosure of the pro forma effects on net income and net income per share as if compensation cost had been recognized based upon the fair value-based method at the date of grant of options awarded.

     The following table reflects pro forma net income and net income per share had the Company elected to adopt the fair value-based method (in thousands, except per share data):

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     These pro forma amounts may not be representative of future disclosures since the estimated fair value of stock options is amortized to expense over the vesting period, and additional options may be granted in future years. The pro forma amounts assume that the Company had been following the fair value-based method since the beginning of 1996.

     The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The weighted-average fair value of options granted was $26.47 and $23.87 for the quarters ended April 3, 2004 and March 29, 2003, respectively. Values were estimated using zero dividend yield for all years; expected volatility of 42% and 51% for the quarters ended April 3, 2004 and March 29, 2003, respectively; risk-free interest rates of 3.09% and 2.84% for the quarters ended April 3, 2004 and March 29, 2003, respectively; and weighted-average expected lives of 5.0 years.

(4) Net Income per Share

     Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common and dilutive potential common shares outstanding during the period, using the treasury stock method for options. Of the outstanding options to purchase shares of common stock, for the quarters ended April 3, 2004 and March 29, 2003, options to purchase approximately 374,000 shares and 52,000 shares, respectively, of common stock were not included in the computation of diluted net income per share because the options’ exercise price was greater than the average market price of the common shares.

     The reconciliation of basic and diluted net income per share is as follows (in thousands, except per share amounts):

(5) Comprehensive Income

     Other comprehensive income (loss) consists of unrealized holding gains or losses on the Company’s investments. The following table sets forth the calculation of comprehensive income, net of income taxes (in thousands):

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(6) Feature Film and Co-Production Agreements

Feature Film Agreement

     In 1991, the Company entered into a feature film agreement with Walt Disney Pictures, a wholly owned subsidiary of Walt Disney Pictures and Television (together with its subsidiaries and affiliates collectively referred to herein as “Disney”), to develop and produce up to three computer-animated feature films (the “Feature Film Agreement”). In 1995, the Company released its first and only feature film under the terms of the Feature Film Agreement, Toy Story. The Company continues to receive compensation based on revenue from the distribution of Toy Story and related products. Based on the individual-film-forecast-computation method, all significant Toy Story film production costs were fully amortized by the year ended December 31, 1997.

Co-Production Agreement

     In 1997, the Company extended its original relationship with Disney (under which Toy Story was created and produced) by entering into the Co-Production Agreement. Under the Co-Production Agreement, the Company agreed to produce, on an exclusive basis, five original computer-animated feature films (the “Pictures”) for distribution by Disney. Pixar and Disney agreed to co-finance, co-own and co-brand the Pictures and share equally in the profits of each Picture and any related merchandise and other ancillary products, after Disney recovers all marketing and distribution costs and fees. The first three original Pictures produced under the Co-Production Agreement were A Bug’s Life, Monsters, Inc. and Finding Nemo. The Company is currently in various stages of production on the final two Pictures under this agreement: The Incredibles and Cars. As a sequel, Toy Story 2 did not count toward the Pictures; however, it was produced under the Co-Production Agreement and is afforded the same financial terms as the Pictures. The term of the Co-Production Agreement continues until delivery to Disney of the fifth Picture, Cars, which is currently targeted for a 2005 holiday release.

     All payments to Pixar from Disney for development and production of Toy Story under the Feature Film Agreement, and A Bug’s Life, Toy Story 2, Monsters, Inc., Finding Nemo, The Incredibles and Cars under the Co-Production Agreement have been recorded as cost reimbursements. Accordingly, no revenue has been recognized for such reimbursements; rather, the Company has netted the reimbursements against the related costs.

Creative Development Group

     In addition to the films produced and in process under the Co-Production Agreement, Pixar’s creative development group is working on concept development, pre-production and production for new projects that are not governed by the Co-Production Agreement. Costs related to these projects, including for example, the first feature film produced outside the existing Disney relationship (“Project 2006”), are therefore neither shared nor reimbursed by Disney. Such costs are capitalized as film costs and will be amortized under the individual-film-forecast-computation method assuming the concept development leads to a successful concept and realization of a film project, when it is expected that the film will be set for production. In the event a film is not set for production within three years from the time of the first capitalized transaction, such costs will be expensed.

Components of Capitalized Film Production Costs

     The total film production costs and related amounts capitalized are as follows (in thousands):

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     Under the Co-Production Agreement, certain operating expenses benefiting the productions, such as certain research and development and certain general and administrative expenses, are paid half by Pixar and half by Disney. From the beginning of each respective fiscal year, the Company recorded the following amounts reimbursed by Disney as offsets to the following expense categories (in thousands):

     For released films, the Company expects to amortize, based on current estimates, approximately $9 million to $12 million in capitalized film production costs over the succeeding twelve-month period. This forecast does not include amortization for The Incredibles, which is targeted for release on November 5, 2004. The Company has amortized more than 80% of each released film’s original production costs as of April 3, 2004, with the exception of Finding Nemo, which is projected to reach the 80% milestone by the end of fiscal 2004.

     At April 3, 2004 and January 3, 2004, receivables from Disney aggregated $197.7 million and $197.2 million, respectively, which consists of receivables for film revenue, advances net of Disney’s actual share of production expenditures for all films under the Co-Production Agreement and amounts due for miscellaneous reimbursements.

(7) Segment Reporting

     The chief operating decision-maker is considered to be the Company’s Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a summary basis accompanied by disaggregated information about film revenue for purposes of making operating decisions and assessing financial performance. The summary financial information reviewed by the CEO is identical to the information presented in the accompanying statement of income and the Company has no foreign operations. Therefore, the Company operates in a single operating segment.

     The Company’s revenue segment information by film category follows (in thousands):

(1)

Library titles include Toy Story, A Bug’s Life and Toy Story 2.

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(8) New Accounting Pronouncements

     In April 2003, the Financial Accounting Standards Board (“FASB”) determined that stock-based compensation should be recognized as a cost in the financial statements and that such cost be measured according to the fair value of the stock options. The FASB has not as yet determined the methodology for calculating fair value and plans to issue an accounting standard that would become effective in 2005. The Company will continue to monitor communications on this subject from the FASB in order to determine the impact on the Company’s financial statements.

     In December 2003, the Staff of the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 104 (SAB 104), Revenue Recognition, which supersedes SAB 101, Revenue Recognition in Financial Statements. SAB 104’s primary purpose is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superseded as a result of the issuance of EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” Additionally, SAB 104 rescinds the SEC’s Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (the FAQ) issued with SAB 101 that had been codified in SAB Topic 13, Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB 104. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 in December 2003 did not materially affect the Company’s revenue recognition policies, or the Company’s results of operations, financial position or cash flows.

     In March 2004, the FASB’s Emerging Issues Task Force (EITF) reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. Issue No. 03-1 states that companies carrying debt and equity securities at amounts higher than the securities’ fair values will soon have to use more detailed criteria to evaluate whether to record a loss and will have to disclose additional information about unrealized losses. Issue No. 03-1 is effective for reporting periods beginning after June 15, 2004 and the disclosure requirements are effective for annual reporting periods ending after June 15, 2004. The Company believes that the adoption of EITF No. 03-1 will not have a material effect on its results of operations, financial position or cash flows.

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

     This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995, particularly statements referencing the targeted release dates of our feature films, our target earnings per share for the second quarter of fiscal 2004, our anticipated revenues and operating expenses, our expectations on DVD penetration and the resulting effect on our home video sales and our expectations regarding any future distribution agreement into which we may enter. In some cases, forward-looking statements can be identified by the use of words such as “may,” “could,” “would,” “might,” “will,” “should,” “expect,” “forecast,” “predict,” “potential,” “continue,” “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “is scheduled for,” “targeted,” and variations of such words and similar expressions. Such forward-looking statements are based on current expectations, estimates, and projections about our industry, management’s beliefs, and assumptions made by management. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict; therefore, actual results and outcomes may differ materially from what is expressed or forecasted in any such forward-looking statements. Such risks and uncertainties include those set forth herein under “Risk Factors” on pages 15 through 24. Particular attention should be paid to the cautionary language in Risk Factors “— To meet our fiscal 2004 earnings projections, we are dependent on our feature films and the accuracy of our forecasts,” “— Our operating results have fluctuated in the past, and we expect such fluctuations to continue,” “— Our scheduled successive releases of feature films will continue to place a significant strain on our resources,” and “— The Co-Production Agreement imposes several risks and restrictions on us.” Unless required by law, Pixar undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

     The following discussion should be read in conjunction with the section entitled “Risk Factors” on pages 15 through 24 below and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended January 3, 2004 in addition to our interim financial statements and notes included elsewhere in this report.

Overview

     Pixar was formed in 1986 when Steve Jobs purchased the computer division of Lucasfilm and incorporated it as a separate company. In 1991, we entered into a feature film agreement (the “Feature Film Agreement”) with Walt Disney Pictures, a wholly owned subsidiary of the Walt Disney Company (together with its subsidiaries and affiliates collectively referred to herein as “Disney”), for the development and production of up to three animated feature films to be marketed and distributed by Disney. It was pursuant to the Feature Film agreement that Toy Story was developed, produced, and distributed. Our share of revenues and expenses from Toy Story is governed by the terms of the Feature Film Agreement.

     In February 1997, we entered into the Co-Production Agreement (which, except for certain economic provisions applicable to Toy Story, superseded the Feature Film Agreement) with Disney pursuant to which we, on an exclusive basis, agreed to produce five original computer-animated feature-length theatrical motion pictures (the “Pictures”) for distribution by Disney. Pixar and Disney agreed to co-finance the production costs of the Pictures, co-own the Pictures (with Disney having exclusive distribution and exploitation rights), co-brand the Pictures, and share equally in the profits of each Picture and any related merchandise as well as other ancillary products, after recovery of all marketing and distribution costs (which Disney finances), a distribution fee paid to Disney and any other predefined fees or costs, including any participations provided to talent. The Co-Production Agreement generally provides that we will be responsible for the production of each Picture, while Disney will be responsible for the marketing, promotion, publicity, advertising and distribution of each Picture.

     The Co-Production Agreement also contemplates that with respect to theatrical sequels, made-for-home video sequels, television productions,

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interactive media products and other derivative works related to the Pictures, we will have the opportunity to co-finance and produce such products or to earn passive royalties on such products. We will not share in any theme park revenues generated as a result of the Pictures. Pursuant to the Co-Production Agreement, in addition to co-financing the production costs of the Pictures, Disney will reimburse us for our share of certain general and administrative costs and certain research and development costs that benefit the productions.

     Our second feature film, A Bug’s Life, was released in November 1998 and counted as the first original Picture under the Co-Production Agreement. In November 1999, Toy Story 2, our third animated feature film was released. As a theatrical sequel, Toy Story 2 is a derivative work of the original Toy Story and therefore it does not count toward the five original Pictures to be produced under the Co-Production Agreement. As a derivative work, Toy Story 2 is treated as a Picture under the Co-Production Agreement, and all the provisions applicable to the five original Pictures apply.

     In November 2001, we released Monsters, Inc., our fourth animated feature film, which counts as the second original Picture under the Co-Production Agreement. In May 2003, we released Finding Nemo, our fifth animated feature film, which counts as the third original Picture under the Co-Production Agreement. We are currently in various stages of production on the remaining two films, The Incredibles and Cars. These films will be produced and distributed under the Co-Production Agreement and will count as the fourth and fifth films of the Pictures to be produced under the Co-Production Agreement. The Incredibles is scheduled to be released November 5, 2004 and Cars is currently scheduled for a 2005 holiday release.

     The term of the Co-Production Agreement continues until delivery to Disney of Cars. Since the delivery of Finding Nemo, we have had the ability to negotiate and enter into another distribution agreement with any other third party. We have produced five highly successful films to date, and we believe that this success combined with the strength of our financial resources, position us to negotiate a distribution arrangement beyond the Co-Production Agreement with more favorable economic terms and full ownership of our films. In January 2004, we announced that we had ended our discussions with Disney on extending our existing arrangement with them. We are currently exploring other alternatives. Although we look forward to a more favorable agreement for films released after Cars, we also understand that ending our relationship with Disney may increase some of the risks we face in the motion picture industry. See “Risk Factors — The Co-Production Agreement imposes several risks and restrictions on us,” “Risk Factors — We experience intense competition with respect to our animated feature films, animation products, and software” and “Risk Factors — We face various distribution risks with respect to our feature films.”

     All payments to us from Disney for development and production of Toy Story under the Feature Film Agreement, and A Bug’s Life, Toy Story 2, Monsters, Inc., Finding Nemo, The Incredibles and Cars under the Co-Production Agreement have been recorded as cost reimbursements. Accordingly, no revenue has been recognized for such reimbursements; rather, we have netted the reimbursements against the related costs.

     The statements regarding the targeted release dates for our future films are forward-looking, and the actual release dates may differ. Factors that could cause delays in the release of our films include, but are not limited to: (1) the uncertainties related to production delays; (2) financing requirements; (3) personnel availability; (4) external socioeconomic and political events; and (5) the release dates of competitive films. Please see “Risk Factors” for a more detailed discussion of these factors.

Target Earnings per Share for the Second Quarter of Fiscal 2004

     We expect continuing international home video revenues from Finding Nemo to drive our results for the second quarter, particularly from its release in Spain, France, and Japan. Based on the popularity of the film at the international box office, and considering the growing trends of the DVD format, our home video sales projections are now expected to trend higher than those of Monsters, Inc. However, we anticipate that these gains will be somewhat mitigated by increases in marketing costs. Our net units take into account certain return reserves for the Finding Nemo home video which differ from those estimated by Disney. We will evaluate these projections on a quarterly basis and adjust them in future periods, if necessary. Revenues from the domestic pay television licensing of Finding Nemo are also expected in the second quarter, along with some contributions from merchandise and home video for our films. Accordingly, we are targeting diluted earnings per share of approximately $0.30 for the second quarter of fiscal 2004.

     These statements regarding our targeted earnings per share are forward-looking, and actual results may differ materially. Factors that could cause actual results for the second quarter of fiscal 2004 to differ include, but are not limited to: (1) the timing and amount of worldwide revenues and distribution costs from The Incredibles, Finding Nemo, Monsters, Inc. and other titles in our film library, (2) the timing, accuracy, and sufficiency of the information we receive from Disney to determine revenues and associated gross profits, (3) the timing and amount of non-film related revenues and expenses, (4) the accuracy of assumptions and judgments used to estimate certain revenues and associated gross profits, (5) the market price of our common stock and related volatility, (6) potential delays in the release dates of our films, (7) final terms of our future distribution deal, and (8) external socioeconomic and political events that are beyond our control. Please see “Risk Factors” for a more detailed discussion of these factors.

Recent Developments

Changes in Management

     In March 2004, we announced that Ann Mather, Executive Vice President and Chief Financial Officer, will retire in May 2004 to devote more time to her family. We also announced that Simon Bax would become Pixar’s new Executive Vice President and Chief Financial Officer in May 2004. Mr. Bax has over 20 years of financial operations experience, including more than 7 years as the Chief Financial Officer of Fox Filmed Entertainment.

Critical Accounting Policies

Revenue Recognition

     We recognize film revenue from the distribution of our animated feature films and related products when earned and reasonably estimable in

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accordance with Statement of Position 00-2 — “Accounting by Producers or Distributors of Films” (SOP 00-2). The following are the conditions that must be met in order to recognize revenue in accordance with SOP 00-2:

•		persuasive evidence of a sale or licensing arrangement with a customer exists;
•		the film is complete and, in accordance with the terms of the arrangement, has been delivered or is available for immediate and unconditional delivery;
•		the license period of the arrangement has begun and the customer can begin its exploitation, exhibition or sale;
•		the arrangement fee is fixed or determinable; and
•		collection of the arrangement fee is reasonably assured.

     Under the Co-Production Agreement, we share equally with Disney in the profits of Finding Nemo, Monsters, Inc., Toy Story 2 and A Bug’s Life after Disney recovers its marketing, distribution and other predefined costs and fees. Our revenues for Toy Story are governed by the terms of the Feature Film Agreement. The amount of revenue recognized in any given quarter or quarters from all of our films depends on the timing, accuracy and sufficiency of the information we receive from Disney to determine revenues and associated gross profits. Although Disney provides us with the most current information available to enable us to recognize our share of revenue and determine our film gross profit, in the past we have made adjustments, and we are likely to make adjustments in the future, to that information based on our estimates and judgments. For example, in the past, our theatrical revenues have been adjusted for our estimated reserves on potential uncollectible amounts to be received from theatrical exhibitors. We also make adjustments to our home video revenues for estimates on return reserves that may differ from those reported by Disney. Disney may provide us with reserve information that may differ substantially from our historical experience with our previous titles. Unless we obtain compelling explanations for such differences, we have and may continue to record reserves more in line with our historical experience. The estimates on reserves may be adjusted in future periods as additional information becomes available, such as actual rates of returns, inventory levels in the distribution channel, as well as other business and industry information.

     We also utilize margin normalization, such as with merchandising or home video, in accordance with the provisions of SOP 00-2. This may result in the utilization of budgeted or forecasted information rather than actual costs incurred if it is deemed to be a more accurate reflection of our participation. Similar to return reserves, these expense estimates are reviewed and may be adjusted periodically to ensure the most accurate depiction of our participation is reflected. We also have the right to audit Disney’s books and records related to the Pictures according to the terms of the Co-Production Agreement. Additionally, during the fourth quarter of fiscal 2003 and the first quarter of fiscal 2004, our fiscal reporting periods differed from that of Disney. Consequently, it was necessary to use a combination of information from Disney and our own estimates to determine our revenues for the periods between Disney’s fiscal period end and ours. Any revenue received in advance from Disney is deferred and recorded as revenue when earned.

     Any adjustments resulting from changes to our estimated reserves, margin normalization or updated information from Disney, noted above, could have a material effect on our financial statements in any given quarter or quarters. For example, during 2002 and 2003, there were a number of adjustments to our earnings resulting from the aforementioned estimates, as well as our reliance on Disney. During fiscal 2002, one-time adjustments to A Bug’s Life and Toy Story 2 home video reserves and margins and merchandising revenues had a positive net impact of $0.19 to our diluted net income per share. We also received updated information from Disney in the first quarter of fiscal 2003, which decreased previously recorded home video expenses by $3.2 million for all of our film titles on a cumulative basis. This resulted in an increase of $0.03 to our diluted net income per share for our first quarter of fiscal 2003. During the second quarter of fiscal year 2003, we recognized an adjustment which reduced our Monsters, Inc. domestic home video revenue after we received updated information from Disney, which reflected higher returns of domestic home video than had been originally anticipated. This adjustment reduced our home video revenues by $4.4 million and had a net impact of $0.04 to our diluted net income per share in the second quarter of fiscal 2003. We also received a settlement on Monsters, Inc. merchandise revenue for the third quarter of fiscal 2003, which resulted in an increase of $3.5 million to our revenues and $0.03 to our diluted net income per share.

     In accordance with the provisions of SOP 00-2, a film is classified as a library title after three years from the film’s initial release. Currently, Toy Story, A Bug’s Life and Toy Story 2 are classified as library titles. Monsters, Inc. will be classified as a library title beginning in the third quarter of fiscal 2004. The term library titles is used solely for the purpose of classification and for identifying previously released films in accordance with the provisions of SOP 00-2. Revenue recognition for such titles is in accordance with our revenue recognition policy for film revenue.

     Software Revenue

     Revenue for software licenses are recognized in compliance with SOP 97-2 “Software Revenue Recognition” as amended by SOP 98-9 “Modification of SOP 97-2, With Respect to Certain Transactions.” Under SOP 97-2, as amended, we recognize revenues when all of the following conditions are met:

•		persuasive evidence of an agreement exists;
•		delivery of the product has occurred;
•		the fee is fixed or determinable; and
•		collection of these fees is probable.

     SOP 97-2, as amended, generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. Revenue recognized from multiple-element arrangements is allocated to undelivered elements of the

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arrangement, such as support services, based on the relative fair values of the elements. Our determination of fair value of each element in multi-element arrangements is based on vendor-specific objective evidence (VSOE). We limit our assessment of VSOE for each element to either the price charged when the same element is sold separately or the price established by management, having the relevant authority to do so, for an element not yet sold separately.

     Software maintenance is recorded as deferred revenue and is recognized ratably over the term of the agreement, which is generally twelve months.

Film Production Costs

     We capitalize our share of direct film production costs in accordance with SOP 00-2. Film production costs include costs to develop and produce computer animated motion pictures, which primarily consists of salaries, equipment and overhead. With regard to the Pictures, we capitalize film production costs in excess of reimbursable amounts from Disney. With respect to Project 2006, our first feature film outside of our existing Disney relationship, and beyond, we capitalize all film production costs. Production overhead, a component of film costs, includes allocable costs of individuals or departments with exclusive or significant responsibility for the production of our films. Capitalized production overhead does not include administrative, general and research and development expenses. In addition to the films produced, we are also working on concept development for several new projects.

     Once a film is released, capitalized film production costs will be amortized in the proportion that the revenue during the period for each film bears to the estimated revenue to be received from all sources under the individual-film-forecast-computation method. The amount of film costs that will be amortized each quarter will depend on how much future revenue we expect to receive from each film. We make certain estimates and judgments of our future gross revenues to be received for each film based on information received from Disney, and our knowledge of the industry. Estimates of anticipated total gross revenues are reviewed periodically and may be revised if necessary. A change to the estimate of gross revenues for an individual film may result in an increase or decrease to the percentage of amortization of capitalized film costs relative to a previous period. Unamortized film production costs are compared with net realizable value each reporting period on a film-by-film basis. If estimated remaining gross revenues are not sufficient to recover the unamortized film production costs, the unamortized film production costs will be written down to fair value.

Results of Operations

     Our results for the quarter ended April 3, 2004 were driven primarily by worldwide home video revenue, continuing foreign theatrical revenue, merchandising, and ancillary royalties from Finding Nemo as well as continued worldwide home video revenue and merchandising from Monsters, Inc. and our library titles.

Revenue

     Total revenue, which consists of film revenue and software revenue, was $53.8 million for the quarter ended April 3, 2004 compared to $18.7 million in the corresponding prior year period. The period-over-period increase was largely due to the timing and success of Finding Nemo’s worldwide home video performance and continued foreign theatrical revenues in the first quarter of fiscal 2004.

     Film revenue for the quarter ended April 3, 2004 was $51.1 million compared with $16.4 million in the corresponding prior year period. The increase in revenues for the current quarter as compared to the corresponding prior year quarter is due primarily to Finding Nemo. Film revenue for the quarter ended April 3, 2004 consisted of $40.2 million from Finding Nemo related primarily to worldwide home video revenue, worldwide theatrical revenues, merchandising, and ancillary royalties. Also included in our film revenues for the first quarter ended April 3, 2004 was $8.3 million from our library titles, which consisted of merchandise sales, worldwide home video sales and ancillary royalties and $2.4 million from Monsters, Inc.

     Film revenue for the quarter ended March 29, 2003 consisted of $8.6 million from Monsters, Inc., which related primarily to revenues from domestic pay television licensing, and to a lesser extent, revenues from pay-per-view and merchandise sales. Also included in our film revenue for the first quarter ended March 29, 2003 was $7.7 million from our library titles, which consisted of continued worldwide home video sales, merchandise sales, international television licensing and ancillary royalties. During the first quarter of fiscal 2003, we received additional information from Disney that decreased home video expenses for all of our film titles on a cumulative basis and contributed approximately $3.2 million to our net revenues and $0.03 to our fully diluted net income per share.

     In May 2003, two of our library titles, Toy Story and Toy Story 2, were placed on a domestic home video sales moratorium.

     Software revenue includes software license revenue, principally from RenderMan®, and royalty revenue from licensing Physical Effects, Inc. (“PEI”) technology to a third party. PEI, a company we acquired in 1998, licensed certain of its technology to a third party, from which we receive associated royalty revenue on a quarterly basis. Software revenue for the quarter ended April 3, 2004 was $2.7 million compared to $2.3 million in the corresponding prior year period, resulting from increases in RenderMan® software licensing sales during the period. In spite of the increase in software revenue for the quarter ended April 3, 2004, our primary focus is on content creation for animated feature films and related products, and as a result, we have not increased the time and resources necessary to generate consistently higher RenderMan® license revenues. Therefore, we continue to expect ongoing variability in revenues derived from software licenses. Software maintenance contracts are recorded as unearned revenue and recognized ratably over the term of the agreement, which is generally twelve months.

     For the quarter ended April 3, 2004, Disney accounted for 92% of our total revenue compared to 89% for the corresponding prior year period. The revenue from Disney consisted primarily of film related revenue. Because of our relationship with Disney under the Co-Production Agreement, Disney is expected to continue to represent significantly greater than 10% of our revenue in 2004 and for the near future.

Cost of Revenue

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     Cost of revenue includes cost of film revenue and cost of software revenue. Cost of film revenue for the quarter ended April 3, 2004 was $5.9 million compared to $2.9 million in the corresponding prior year period. Cost of film revenue represents amortization of capitalized film production costs. See “Capitalized Film Production Costs” below. For the quarter ended April 3, 2004, cost of film revenue represented amortization of capitalized film production costs associated with Finding Nemo, Monsters, Inc., Toy Story 2 and A Bug’s Life, and represented 12% of total film revenue as compared to 18% for the corresponding prior year period. The decrease in cost of film revenue as a percentage of total film revenue for the quarter ended April 3, 2004 compared to the prior year period can be attributable to a higher proportion of revenues resulting from Finding Nemo, which had a lower amortization percentage than Monsters, Inc. in the prior period, since we expect to receive more revenues from Finding Nemo over its lifetime. Additionally, the cost amortization percentages from Monsters, Inc. and our library titles have declined in the current quarter relative to the corresponding prior year period due to increases in their ultimate revenues.

     Cost of software revenue consists of the direct costs and manufacturing overhead required to reproduce and package our software products. Cost of software revenue as a percentage of the related revenue was less than 1% for the quarter ended April 3, 2004 as compared to 1% for the corresponding prior year period.

Operating Expenses

     Total operating expenses were $6.8 million for the quarter ended April 3, 2004 compared to $5.1 million in the corresponding prior year period. The increase in operating expenses over the prior year period reflects the growth experienced by the studio as we ramp up to meet the demands of multiple films in production and an increased proportion of operating expenses previously shared with Disney. Under the Co-Pr