UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 3, 2004

or

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

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).

     The number of shares outstanding of the Registrant’s Common Stock as of August 4, 2004 was 56,541,329.

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.

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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 for the year ended January 3, 2004 as filed with the Securities and Exchange Commission.

     The results of operations for the quarter and six months ended July 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 fiscal 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.

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     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):

     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 $27.07 and $26.92 for the quarter and six months ended July 3, 2004, respectively, and $24.70 and $23.95 for the quarter and six months ended June 28, 2003, respectively. Values were estimated using zero dividend yield for all years; expected volatility of 39% for the quarter and six months ended July 3, 2004, and 50% and 51%, respectively, in the corresponding prior year periods; risk-free interest rates of 3.77% and 3.59% for the quarter and six months ended July 3, 2004, respectively, and 2.55% and 2.81%, respectively, for the corresponding prior year periods; and weighted-average expected lives for all periods 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 quarter and six months ended July 3, 2004, options to purchase approximately 506,000 shares and 520,000 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. Options to purchase approximately 59,000 shares and 56,000 shares, respectively, of common stock were excluded for the quarter and six month periods ended June 28, 2003.

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(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):

(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.

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Co-Production Agreement

     In 1997, the Company 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 the Company, 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, 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 $5 million to $8 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 July 3, 2004, with the exception of Finding Nemo, which is projected to reach the 80% milestone by the end of fiscal 2004.

     At July 3, 2004 and January 3, 2004, receivables from Disney aggregated $23.9 million and $206.6 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) During the three months ended June 28, 2003, we recognized an adjustment, which reduced our revenues for Monsters, Inc. domestic home video after we received additional 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.

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

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(8) New Accounting Pronouncements

     On March 31, 2004, the FASB issued a proposed Statement, Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25 and generally would require instead that such transactions be accounted for using a fair-value-based method. If adopted in its current form, the proposed Statement would be effective for fiscal years beginning after December 15, 2004.

     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 anticipated operating expenses and capital expenditures, 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 18 through 33. Particular attention should be paid to the cautionary language in Risk Factors "— Our operating results are primarily dependent on the success of our feature films, and forecasting is extremely difficult,” “— 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 18 through 33 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

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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, 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 post-production on The Incredibles and in production on 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 domestic theatrical release of The Incredibles is scheduled for November 5, 2004, and Cars is currently scheduled for a 2005 holiday release. We are also in production on Project 2006, our first feature film outside of our Disney relationship.

     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. Although we look forward to a more favorable arrangement 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.

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     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.

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 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 an