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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number 0-24363
INTERPLAY ENTERTAINMENT CORP.
(Exact name of the registrant as specified in its charter)
DELAWARE 33-0102707
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
16815 VON KARMAN AVENUE, IRVINE, CALIFORNIA 92606
(Address of principal executive offices)
(949) 553-6655
(Registrant's telephone number, including area code)
Securities registered pursuant of Section 12 (b) of the Act: None
Securities registered pursuant of Section 12 (g) of the Act:
COMMON STOCK, $0.001 PAR VALUE
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 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. [X]
As of April 10, 2002, 93,060,857 shares of Common Stock of the Registrant
were issued and outstanding and the aggregate market value of voting common
stock held by non-affiliates was $3,032,659.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement for the issuer's 2002 Annual Meeting
of Stockholders are incorporated by reference into Part III of this Report.
INTERPLAY ENTERTAINMENT CORP.
INDEX TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2001
PAGE
PART I
Item 1. Business 4
Item 2. Properties 11
Item 3. Legal Proceedings 12
Item 4. Submission of Matters to a Vote of Security Holders 12
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 12
Item 6. Selected Financial Data 13
Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations 14
Item 7A. Quantitative and Qualitative Disclosure about
Market Risk 36
Item 8. Consolidated Financial Statements and
Supplementary Data 37
Item 9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure 37
PART III
Item 10. Directors and Executive Officers of the Registrant 37
Item 11. Executive Compensation 37
Item 12. Security Ownership of Certain Beneficial Owners
and Management 37
Item 13. Certain Relationships and Related Transactions 37
PART IV
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K 38
Signatures 39
Exhibit Index 41
Page 2
THIS FORM 10-K CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS WITHIN THE
MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE
SECURITIES AND EXCHANGE ACT OF 1934 AND SUCH FORWARD-LOOKING STATEMENTS ARE
SUBJECT TO THE SAFE HARBORS CREATED THEREBY. FOR THIS PURPOSE, ANY STATEMENTS
CONTAINED IN THIS FORM 10-K EXCEPT FOR HISTORICAL INFORMATION MAY BE DEEMED TO
BE FORWARD-LOOKING STATEMENTS. WITHOUT LIMITING THE GENERALITY OF THE FOREGOING,
WORDS SUCH AS "MAY," "WILL," "EXPECT," "BELIEVE," "ANTICIPATE," "INTEND,"
"COULD," "ESTIMATE" OR "CONTINUE" OR THE NEGATIVE OR OTHER VARIATIONS THEREOF OR
COMPARABLE TERMINOLOGY ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. IN
ADDITION, ANY STATEMENTS THAT REFER TO EXPECTATIONS, PROJECTIONS OR OTHER
CHARACTERIZATIONS OF FUTURE EVENTS OR CIRCUMSTANCES ARE FORWARD-LOOKING
STATEMENTS.
THE FORWARD-LOOKING STATEMENTS INCLUDED IN THIS FORM 10-K ARE BASED ON
CURRENT EXPECTATIONS THAT INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES, AS WELL
AS CERTAIN ASSUMPTIONS. FOR EXAMPLE, ANY STATEMENTS REGARDING FUTURE CASH FLOW,
FINANCING ACTIVITIES, COST REDUCTION MEASURES, REPLACEMENT OF THE COMPANY'S
TERMINATED LINE OF CREDIT ARE FORWARD-LOOKING STATEMENTS AND THERE CAN BE NO
ASSURANCE THAT THE COMPANY WILL GENERATE POSITIVE CASH FLOW IN THE FUTURE OR
THAT THE COMPANY WILL BE ABLE TO OBTAIN FINANCING ON SATISFACTORY TERMS, IF AT
ALL, OR THAT ANY COST REDUCTIONS EFFECTED BY THE COMPANY WILL BE SUFFICIENT TO
OFFSET ANY NEGATIVE CASH FLOW FROM OPERATIONS; OR THAT THE COMPANY WILL BE ABLE
TO RENEW OR REPLACE ITS LINE OF CREDIT. ADDITIONAL RISKS AND UNCERTAINTIES
INCLUDE POSSIBLE DELAYS IN THE COMPLETION OF PRODUCTS, THE POSSIBLE LACK OF
CONSUMER APPEAL AND ACCEPTANCE OF PRODUCTS RELEASED BY THE COMPANY, FLUCTUATIONS
IN DEMAND, LOST SALES BECAUSE OF THE RESCHEDULING OF PRODUCT LAUNCHES OR ORDER
DELIVERIES, FAILURE OF THE COMPANY'S MARKETS TO CONTINUE TO GROW, THAT THE
COMPANY'S PRODUCTS WILL REMAIN ACCEPTED WITHIN THEIR RESPECTIVE MARKETS, THAT
COMPETITIVE CONDITIONS WITHIN THE COMPANY'S MARKETS WILL NOT CHANGE MATERIALLY
OR ADVERSELY, THAT THE COMPANY WILL RETAIN KEY DEVELOPMENT AND MANAGEMENT
PERSONNEL, THAT THE COMPANY'S FORECASTS WILL ACCURATELY ANTICIPATE MARKET DEMAND
AND THAT THERE WILL BE NO MATERIAL ADVERSE CHANGES IN THE COMPANY'S OPERATIONS
OR BUSINESS. ADDITIONAL FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS ARE
DISCUSSED IN MORE DETAIL IN "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS--FACTORS AFFECTING FUTURE PERFORMANCE".
ASSUMPTIONS RELATING TO THE FOREGOING INVOLVE JUDGMENTS WITH RESPECT TO, AMONG
OTHER THINGS, FUTURE ECONOMIC, COMPETITIVE AND MARKET CONDITIONS, AND FUTURE
BUSINESS DECISIONS, ALL OF WHICH ARE DIFFICULT OR IMPOSSIBLE TO PREDICT
ACCURATELY AND MANY OF WHICH ARE BEYOND THE CONTROL OF THE COMPANY. ALTHOUGH THE
COMPANY BELIEVES THAT THE ASSUMPTIONS UNDERLYING THE FORWARD-LOOKING STATEMENTS
ARE REASONABLE, THE BUSINESS AND OPERATIONS OF THE COMPANY ARE SUBJECT TO
SUBSTANTIAL RISKS THAT INCREASE THE UNCERTAINTY INHERENT IN THE FORWARD-LOOKING
STATEMENTS, AND THE INCLUSION OF SUCH INFORMATION SHOULD NOT BE REGARDED AS A
REPRESENTATION BY THE COMPANY OR ANY OTHER PERSON THAT THE OBJECTIVES OR PLANS
OF THE COMPANY WILL BE ACHIEVED. IN ADDITION, RISKS, UNCERTAINTIES AND
ASSUMPTIONS CHANGE AS EVENTS OR CIRCUMSTANCES CHANGE. THE COMPANY DISCLAIMS ANY
OBLIGATION TO PUBLICLY RELEASE THE RESULTS OF ANY REVISIONS TO THESE
FORWARD-LOOKING STATEMENTS WHICH MAY BE MADE TO REFLECT EVENTS OR CIRCUMSTANCES
OCCURRING SUBSEQUENT TO THE FILING OF THIS FORM 10-K WITH THE SEC OR OTHERWISE
TO REVISE OR UPDATE ANY ORAL OR WRITTEN FORWARD-LOOKING STATEMENT THAT MAY BE
MADE FROM TIME TO TIME BY OR ON BEHALF OF THE COMPANY.
INTERPLAY (R), INTERPLAY PRODUCTIONS(R) AND CERTAIN OF THE COMPANY'S
PRODUCT NAMES AND PUBLISHING LABELS REFERRED TO IN THIS FORM 10-K ARE THE
COMPANY'S TRADEMARKS. THIS ANNUAL REPORT ON FORM 10-K ALSO CONTAINS TRADEMARKS
BELONGING TO OTHERS.
Page 3
PART I
ITEM 1. BUSINESS
OVERVIEW AND RECENT DEVELOPMENTS
Interplay Entertainment Corp. is a leading developer and publisher of
interactive entertainment software for both core gamers and the mass market. We
were incorporated in the State of California in 1982 and were reincorporated in
the State of Delaware in May 1998. We are most widely known for our titles in
the action/arcade, adventure/role playing game (RPG), and strategy/puzzle
categories. We have produced titles for many of the most popular interactive
entertainment software platforms, and currently balance our publishing and
distribution business by developing interactive entertainment software for PCs
and next generation video game consoles, such as the Sony PlayStation 2,
Microsoft Xbox and Nintendo GameCube.
We seek to publish interactive entertainment software titles that are, or
have the potential to become, franchise software titles that can be leveraged
across several releases and/or platforms, and have published many such
successful franchise titles to date. In addition, we hold licenses to use
popular brands, such as Advanced Dungeons and Dragons, Matrix, Star Trek and
Caesars Palace, for incorporation into certain of our products.
In April 2001, we completed a private placement of 8,126,770 units
consisting of one share of common stock and one warrant to purchase an
additional share of common stock for total proceeds of $12.7 million, and
received net proceeds of approximately $11.7 million. In April 2001, we also
obtained a new line of credit to fund our operations. Due to our failure to meet
certain financial covenants, the bank terminated the line of credit in October
2001. The termination of the line of credit has had, and continues to have, a
material negative impact on our capital resources, and has required us to take
many cost-cutting measures including a 32 percent reduction in our personnel
during 2001.
In August 2001, we entered into a distribution agreement with Vivendi
Universal Games, Inc., formerly known as Vivendi Universal Interactive
Publishing North America, Inc., providing for Vivendi to become our distributor
in North America through December 31, 2003 for substantially all of our
products, with the exception of products with pre-existing distribution
agreements. As a result of engaging Vivendi as our North America distributor, we
now distribute substantially all of our products through distributors. Our other
major distributor is Virgin Interactive Entertainment Limited, a wholly owned
subsidiary of Titus Interactive S.A. that distributes substantially all of our
titles in Europe, the Commonwealth of Independent States, Africa and the Middle
East. Consequently, we have substantially reduced our internal product
distribution capacity, including our sales and marketing capacity and are
allocating our resources towards product development and publishing.
In addition to our agreement with Vivendi, in fiscal 2001, we experienced a
number of significant changes in our business and operations. In August 2001,
Titus Interactive S.A., which currently holds 72 percent of our outstanding
common stock, converted a portion of its Series A Preferred Stock into common
stock and used the increased voting power resulting form this conversion to
elect a new board of directors at our 2001 annual meeting. Once in place, our
newly constituted board appointed new members to our senior management team,
including a Chief Administration Officer, a new Chief Executive Officer and a
new Chief Financial Officer. Furthermore, Titus engaged Europlay I, LLC, an
investment banking firm with experience in the interactive entertainment
industry, to assist us with restructuring our operations.
In late 2001, we determined that it was in our best interest to raise money
through the sale of some of our significant assets. With the assistance of
Europlay, in early 2002, we began an auction process for the sale of our product
development subsidiary, Shiny Entertainment, Inc., which has developed past
successful video games including MESSIAH, SACRIFICE and MDK, and currently is
developing video games based on the motion picture currently titled "THE MATRIX
II: RELOADED." We are currently in the advanced stages of negotiation with a
potential buyer.
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PRODUCTS
We develop and publish interactive entertainment software titles that
provide immersive game experiences by combining advanced technology with
engaging content, vivid graphics and rich sound. We utilize the experience and
judgment of the avid gamers in our product development group to select and
produce the products we publish. Our strategy is to invest in products for those
platforms, whether PC or video game console, that have or will have sufficient
installed bases for the investment to be economically viable. We currently
develop and publish products for the PC platform compatible with Microsoft
Windows, and for video game consoles such as the Sony PlayStation 2. We also
develop and have plans to publish products for the Microsoft Xbox and Nintendo
GameCube video game consoles. In addition, we anticipate substantial growth in
the use of high-speed Internet access, which could possibly provide
significantly expanded technical capabilities for the PC platform.
We assess the potential acceptance and success of emerging platforms and
the anticipated continued viability of existing platforms based on many factors,
including the number of competing titles, the ratio of software sales to
hardware sales with respect to the platform, the platform's installed base,
changes in the rate of the platform's sales and the cost and timing of
development for the platform. We must continually anticipate and assess the
emergence of, and market acceptance of, new interactive entertainment software
platforms well in advance of the time the platform is introduced to consumers.
Because product development cycles are difficult to predict, we are required to
make substantial product development and other investments in a particular
platform well in advance of the platform's introduction. If a platform for which
we develop software is not released on a timely basis or does not attain
significant market penetration, our business, operating results and financial
condition could be materially adversely affected. Alternatively, if we fail to
develop products for a platform that does achieve significant market
penetration, then our business, operating results and financial condition could
also be materially adversely affected.
We have entered into license agreements with Sega, Sony Computer
Entertainment, Microsoft Corporation and Nintendo pursuant to which the Company
has the right to develop, sublicense, publish, and distribute products for the
licensor's respective platforms in specified territories. In certain cases, the
products are manufactured for us by the licensor. We pay the licensor a royalty
or manufacturing fee in exchange for such license and manufacturing services.
Such agreements grant the licensor certain approval rights over the products
developed for their platform, including packaging and marketing materials for
such products. There can be no assurance that we will be able to obtain future
licenses from platform companies on acceptable terms or that any existing or
future licenses will be renewed by the licensors. Our inability to obtain such
licenses or approvals could have a material adverse effect on our business,
operating results and financial condition. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Factors Affecting
Future Performance--Dependence on Licenses from and Manufacturing by Hardware
Companies."
The interactive entertainment software industry is highly seasonal, with
the highest levels of consumer demand occurring during the year-end holiday
buying season. As a result, our net revenues, gross profits and operating income
have historically been highest during the second half of the year. The impact of
this seasonality will increase as we rely more heavily on game console net
revenues in the future. Seasonal fluctuations in revenues from game console
products may cause material harm to our business and financial results.
PRODUCT DEVELOPMENT
We develop or acquire our products from a variety of sources, including our
internal development studios, our subsidiary Shiny Entertainment, Inc. and
publishing relationships with leading independent developers.
THE DEVELOPMENT PROCESS. We develop original products both internally,
using our in-house development staff, and externally, using third party software
developers working under contract with us. Producers on our internal staff
monitor the work of both inside and third party development teams through design
review, progress evaluation, milestone review and quality assurance. In
particular, each milestone submission is thoroughly evaluated by our product
development staff to ensure compliance with the product's design specifications
and our quality standards. We enter into consulting or development agreements
with third party developers, generally on a flat-fee, work-for-hire basis or on
a royalty basis, whereby we pay development fees or royalty advances based on
the achievement of milestones. In royalty arrangements,
Page 5
we ultimately pay continuation royalties to developers once our advances have
been recouped. In addition, in certain cases, we will utilize third party
developers to convert products for use with new platforms.
Our products typically have short life cycles, and we therefore depend on
the timely introduction of successful new products, including enhancements of or
sequels to existing products and conversions of previously-released products to
additional platforms, to generate revenues to fund operations and to replace
declining revenues from existing products. The development cycle of new products
is difficult to predict, and involves a number of risks. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Factors Affecting Future Performance--Dependence on New Product
Introductions; Risk of Product Delays and Product Defects."
During the years ended December 31, 2001, 2000 and 1999, we spent $20.6
million, $22.2 million and $20.6 million, respectively, on product research and
development activities. Those amounts represented 36 percent, 21 percent and 20
percent, respectively, of revenue in each of those periods.
INTERNAL PRODUCT DEVELOPMENT
U.S. PRODUCT DEVELOPMENT. Our internal product development group in the
United States (excluding Shiny's development group) consisted of approximately
147 people at December 31, 2001. Once we select a design for a product, we
establish a production team, development schedule and budget for the product.
Our internal development process includes initial design and concept layout,
computer graphic design, 2D and 3D artwork, programming, prototype testing,
sound engineering and quality control. The development process for an original,
internally developed product typically takes from 12 to 24 months, and six to 12
months for the porting of a product to a different technology platform. We
utilize a variety of advanced hardware and software development tools, including
animation, sound compression utilities and video compression for the production
and development of our interactive entertainment software titles. Our internal
development organization is divided into separate studios, each dedicated to the
production and development of products for a particular product category. Within
each studio, development teams are assigned to a particular project. These teams
are generally led by a producer or associate producer and include game
designers, software programmers, artists, product managers and sound
technicians. We believe that the separate studios approach promotes the creative
and entrepreneurial environment necessary to develop innovative and successful
titles. In addition, we believe that breaking down the development function into
separate studios enables us to improve our software design capabilities, to
better manage our internal and external development processes and to create and
enhance our software development tools and techniques, thereby enabling us to
obtain greater efficiency and improved predictability in the software
development process.
SHINY ENTERTAINMENT. David Perry, Shiny's President and founder, has
produced a number of highly successful interactive entertainment software
titles, including CoolSpot, Aladdin, Earthworm Jim, Earthworm Jim II and MDK.
Shiny currently has one original title in development based on the motion
picture currently titled "THE MATRIX II: RELOADED." Shiny's development group at
December 31, 2001 consisted of approximately 33 people. In early 2002, we began
an auction process for the sale of Shiny, and currently are in the advanced
stages of negotiation with a potential buyer. If the sale is consummated, we
will have no further rights to the MATRIX title.
INTERNATIONAL DEVELOPMENT. During 2001, we discontinued operations of
Interplay Productions Limited, our European subsidiary responsible for our
product development efforts in Europe. Prior to discontinuing its operations,
Interplay Productions Limited engaged and managed the efforts of third party
developers located in various European countries. We currently have one original
product under development in Europe, which we now manage from our corporate
headquarters in Irvine, California.
EXTERNAL PRODUCT DEVELOPMENT
To expand our product offerings to include hit titles created by third
party developers, and to leverage our publishing capabilities, we enter into
publishing arrangements with third party developers. In February 1999, we
entered into a Product Publishing Agreement with Virgin pursuant to which we
agreed to publish substantially all of Virgin's titles in North and South
America and Japan. As part of our April 2001 settlement with Virgin we amended
the Product Publishing Agreement to provide that we would only publish one
future title developed by Virgin. In the years ended December 31, 2001, 2000 and
1999, approximately 80 percent, 70 percent and 75 percent, respectively, of new
products
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we released and which we believe are or will become franchise titles were
developed by third party developers. We expect that the proportion of our new
products which are developed externally may vary significantly from period to
period as different products are released. In selecting external titles to
publish, we seek titles that combine advanced technologies with creative game
design. Our publishing agreements usually provide us with the exclusive right to
distribute, or license another party to distribute, a product on a worldwide
basis (although, in certain instances our rights are limited to a specified
territory). We typically fund external development through the payment of
advances upon the completion of milestones, which advances are credited against
royalties based on sales of the products. Further, our publishing arrangements
typically provide us with ownership of the trademarks relating to the product as
well as exclusive rights to sequels to the product. We manage the production of
external development projects by appointing a producer from one of our internal
product development studios to oversee the development process and work with the
third party developer to design, develop and test the game.
We believe this strategy of cultivating relationships with talented third
party developers, such as the developers of Baldur's Gate and TombRaider,
provides an excellent source of quality products, and a number of our
commercially successful products have been developed under this strategy.
However, our reliance on third party software developers for the development of
a significant number of our interactive software entertainment products involves
a number of risks. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future Performance--
Dependence on Third Party Software Developers."
For information regarding the revenues, profits, losses and total assets
associated with our various business segments, and information regarding the
revenues and assets associated with our geographic segments, see Note 14 of the
notes to our consolidated financial statements included elsewhere in this
Report.
SALES AND DISTRIBUTION
Our sales and distribution efforts are designed to broaden product
distribution, to control product placement and to increase the penetration of
our products in domestic and international markets. Over the past several years,
we have increased our sales and distribution efforts in international markets
through the formation of Interplay Productions, Limited ("Interplay UK"), our
European subsidiary, through our distribution agreement with Virgin covering
Europe, Commonwealth of Independent States, Africa and the Middle East, and
through licensing and third party distribution strategies elsewhere. In 2001, we
discontinued operations at Interplay Productions Limited. We also distribute our
software products through Interplay OEM in bundling transactions with computer,
peripheral and various other companies, as well as through on-line services.
NORTH AMERICA. Prior to entering into our North America distribution
agreement with Vivendi, in North America we sold our products primarily to mass
merchants, warehouse club stores, large computer and software specialty retail
chains and through catalogs and Internet commerce sites. A majority of our North
American retail sales were to direct accounts, and a lesser percentage were to
third party distributors. Our principal direct retail accounts included CompUSA,
Best Buy, Electronics Boutique, Wal-Mart, K-Mart, Target, Toys-r-us and GameStop
(Babbages). Our principal distributors in North America included Navarre and
Softek.
In August 2001, we entered into a distribution agreement with Vivendi,
whereby Vivendi agreed to distribute substantially all of our titles in North
America through December 31, 2003. We continue to distribute products through
catalogs and related promotional materials directly to end-users who can order
products by direct mail, by using a toll-free number, or by accessing our web
site. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Factors Affecting Future Performance--Dependence on
Distribution Channels; Risk of Customer Business Failures; Product Returns."
We seek to extend the life cycle and financial return of many of our
products by marketing those products differently during the various stages of
the product's sales cycle. Although the product sales cycle for a title varies
based on a number of factors, including the quality of the title, the number and
quality of competing titles, and in certain instances seasonality, we typically
consider a title to be a "back catalog" item once it incurs its first price drop
after its initial release. We utilize marketing programs appropriate for each
particular title, which generally include progressive price reductions over time
to increase the product's longevity in the retail channel as we shift our
advertising support to newer releases.
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We provide terms of sale comparable to competitors in our industry. In
addition, we provide technical support for our products in North America through
our customer support department and we provide a 90-day limited warranty to
end-users that our products will be free from manufacturing defects. While to
date we have not experienced any material warranty claims, there can be no
assurance that we will not experience material warranty claims in the future.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations--Factors Affecting Future Performance--Dependence on Distribution
Channels; Risk of Customer Business Failures; Product Returns."
INTERNATIONAL. Prior to February 1999, we distributed our titles in Europe
through Interplay UK, and employed approximately 21 people dedicated to sales
and marketing in the European market. Interplay UK had an agreement with
Infogrames U.K. and Virgin to pool resources in order to distribute PC and video
game console software products to independent software retailers in the United
Kingdom. Interplay UK also had distribution agreements with Acclaim
Entertainment pursuant to which Acclaim distributed certain of our titles in
selected European countries. Net revenues from our distribution agreements with
Acclaim represented 3 percent of our net revenues in the year ended December
31, 1999. In February 1999, we completed an agreement to acquire a 44 percent
ownership interest in VIE Acquisition Group LLC ("VIE"), the parent entity of
Virgin. In connection with this acquisition, we entered into a distribution
agreement with Virgin , pursuant to which Virgin hired Interplay UK's sales and
marketing personnel and commenced distributing substantially all of our titles
in Europe, Commonwealth of Independent States, Africa and the Middle East for a
seven year period. Under the agreement as amended, Virgin earns a distribution
fee for its marketing and distribution of our products, and we reimburse Virgin
for certain direct costs and expenses. As part of our April 2001 settlement with
Virgin, VIE redeemed our ownership interest. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Factors Affecting
Future Performance--Distribution Agreement."
We have built a distribution capability in certain of the developed markets
in Asia and the Americas utilizing third party distribution arrangements for
specified products and platforms. In July 1997, we initiated a licensing
strategy in Japan to expand Japanese sales. We have also licensed a number of
our titles to Sony Computer Entertainment to publish in Japan on the PlayStation
console. In fiscal 2000, we terminated our agreement with Roadshow Entertainment
Pty. Ltd. ("Roadshow") for the Australian market and entered into an agreement
with Tech Pacific Australia Pty Ltd. ("Tech Pacific"), pursuant to which Tech
Pacific acquired the exclusive right to sell and distribute our ongoing PC and
video game console products in Australia. Roadshow continues to market and
distribute our PC and video game console products in New Zealand.
INTERPLAY OEM. Interplay OEM employs approximately 16 people, including 5
in Europe and 2 in Singapore, focused on the distribution of interactive
entertainment software in bundling transactions to the computer hardware
industry. Under these arrangements, one or more software titles, which are
either limited-feature versions or the retail version of a game, are bundled
with computer or peripheral devices and are sold by an original equipment
manufacturer so that the purchaser of the hardware device obtains the software
as part of the hardware purchase. In addition, Interplay OEM has established a
development capability to create modified versions of titles, which support its
customers' technologies. Although it is customary for OEM customers to pay a
lower per unit price on sales through OEM bundling contracts, such arrangements
involve a high unit volume commitment. Interplay OEM net revenues generally are
incremental net revenues and do not have significant additional product
development or sales and marketing costs. There can be no assurance that OEM
sales will generate consistent profits for us, and a decrease in OEM sales or
margins could have a material adverse effect on our business, operating results
and financial condition. In addition to distributing our titles, Interplay OEM
serves as an exclusive OEM distributor for a number of interactive entertainment
software publishers, including Virgin, Grin Inc., MacPlay and Titus. Interplay
OEM's hardware customers include many of the industry's largest computer and
peripheral manufacturers including IBM, Compaq, Packard Bell/NEC, Creative Labs,
Pioneer Electronics, Canon, Dell and Logitech. OEM devotes four employees to
modifying existing products into suitable OEM products. Interplay OEM expanded
its business model to include licensing of the represented software as a premium
to the non-Information Technology marketplace, as well as continuing its
licensing and merchandising activities on behalf of Interplay and Shiny
including television animation, novelizations, strategy guides and other
merchandise tied to our entertainment properties.
Our North American and International ultimate distribution channels are
characterized by continuous change, including consolidation, financial
difficulties of certain retailers, and the emergence of new distributors and new
retail channels such as warehouse chains, mass merchants, computer superstores
and Internet commerce sites. We are exposed
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to the risk of product returns and markdown allowances by our distributors. We
allow our distributors to return defective, shelf-worn and damaged products in
accordance with negotiated terms. We also offer a 90-day limited warranty to our
end users that our products will be free from manufacturing defects. In
addition, we provide markdown allowances, which consist of credits given to
resellers to induce them to lower the retail sales price of certain of our
products to increase sell through and to help the reseller manage its inventory
levels. Although we maintain a reserve for returns and markdown allowances, and
although we manage our returns and markdown allowances through an authorization
procedure, we could be forced to accept substantial product returns and provide
markdown allowances to maintain our access to certain distribution channels. Our
reserve for estimated returns, exchanges, markdowns, price concessions, and
warranty costs was $7.5 million and $6.5 million at December 31, 2001 and 2000,
respectively. Product returns and markdown allowances that exceed our reserves,
if any, could have a material adverse effect on our business, operating results
and financial condition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future
Performance--Dependence on Distribution Channels; Risk of Customer Business
Failures; Product Returns."
MARKETING
Our marketing department is organized into product groups aligned with our
three product development studios and Shiny to promote a focused marketing
strategy and brand image for each studio. Integrated into these product groups
are public relations for each studio. In addition, the marketing department has
four functional groups (web department, event coordination, creative services
and advertising) that support the product groups.
Our marketing department develops and implements marketing programs and
campaigns for each of our titles and product groups. Our marketing activities in
preparation for a product launch include print advertising, game reviews in
consumer and trade publications, retail in-store promotions, attendance at trade
shows and public relations. We also send direct and electronic mail promotional
materials to our database of gamers, and have selectively used radio and
television advertisements in connection with the introduction of certain of our
products. We budget a portion of each product's sales for cooperative
advertising and market development funds with retailers. Every title and brand
is launched with a multi-tiered marketing campaign that is developed on an
individual basis to promote product awareness and customer pre-orders.
We engage in on-line marketing through Internet advertising and the
maintenance of several Internet web sites. These web sites provide news and
information of interest to our customers through free demonstration versions of
games, contests, games, tournaments and promotions. Also, to generate interest
in new product introductions, we provide free demonstration versions of upcoming
titles through magazines and game samples that consumers can download from our
web site. In addition, through our marketing department, we host on-line events
and maintain a vast collection of message boards to keep customers informed on
shipped and upcoming titles.
COMPETITION
The interactive entertainment software industry is intensely competitive
and is characterized by the frequent introduction of new hardware systems and
software products. Our competitors vary in size from small companies to very
large corporations with significantly greater financial, marketing and product
development resources than those ours. Due to these greater resources, certain
of our competitors are able to undertake more extensive marketing campaigns,
adopt more aggressive pricing policies, pay higher fees to licensors of
desirable motion picture, television, sports and character properties and pay
more to third party software developers than us. We believe that the principal
competitive factors in the interactive entertainment software industry include
product features, brand name recognition, access to distribution channels,
quality, ease of use, price, marketing support and quality of customer service.
We compete primarily with other publishers of PC and video game console
interactive entertainment software. Significant competitors include Electronic
Arts Inc., Take Two Interactive Software Inc, THQ Inc., The 3DO Company, Eidos
PLC, Infogrames Entertainment, Activision, Inc., Microsoft Corporation,
LucasArts Entertainment Company, Midway Games Inc., Acclaim Entertainment, Inc.,
Vivendi Universal Games, Inc. and Ubi Soft Entertainment Inc. In addition,
integrated video game console hardware/software companies such as Sony Computer
Entertainment, Microsoft Corporation, Nintendo and Sega compete directly with us
in the development of software titles for their respective platforms. Large
diversified entertainment companies, such as The Walt Disney Company, many of
which own
Page 9
substantial libraries of available content and have substantially greater
financial resources than us, may decide to compete directly with us or to enter
into exclusive relationships with our competitors. We also believe that the
overall growth in the use of the Internet and on-line services by consumers may
pose a competitive threat if customers and potential customers spend less of
their available time using interactive entertainment software and more time on
the Internet and on-line services.
Retailers of our products typically have a limited amount of shelf space
and promotional resources. Consequently, there is intense competition among
consumer software producers, and in particular interactive entertainment
software producers, for high quality retail shelf space and promotional support
from retailers. If the number of consumer software products and computer
platforms increase, competition for shelf space will intensify which may require
us to increase our marketing expenditures. This increased demand for limited
shelf space, places retailers and distributors in an increasingly better
position to negotiate favorable terms of sale, including price discounts, price
protection, marketing and display fees and product return policies. As our
products constitute a relatively small percentage of any retailer's sales
volume, there can be no assurance that retailers will continue to purchase our
products or provide our products with adequate shelf space and promotional
support. A prolonged failure by retailers to provide shelf space and promotional
support would have a material adverse effect on our business, operating results
and financial condition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future
Performance--Industry Competition; Competition for Shelf Space."
MANUFACTURING
Our PC-based products consist primarily of CD-ROMs and DVDs, manuals, and
packaging materials. Substantially all of our CD-ROM and DVD duplication is
performed by unaffiliated third parties. Printing of manuals and packaging
materials, manufacturing of related materials and assembly of completed packages
are performed to our specifications by unaffiliated third parties. To date, we
have not experienced any material difficulties or delays in the manufacture and
assembly of our CD-ROM and DVD based products, and we have not experienced
significant returns due to manufacturing defects.
Sony Computer Entertainment manufactures and ships finished products that
are compatible with its video game consoles to us for distribution. PlayStation
2 products consist of DVDs and include manuals and packaging and are typically
delivered by Sony Computer Entertainment within a relatively short lead-time.
If we experience unanticipated delays in the delivery of manufactured
software products by our third party manufactures, our net sales and operating
results could be materially adversely affected. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Factors Affecting
Future Performance--Dependence on Licenses from and Manufacturing by Hardware
Companies."
INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS
We hold copyrights on our products, product literature and advertising and
other materials, and hold trademark rights in our name, the Interplay logo, our
"By Gamers. For Gamers. (TM)" slogan and certain of our product names and
publishing labels. We also hold rights under a patent application related to the
software engine for one of our products. We have licensed certain products to
third parties for distribution in particular geographic markets or for
particular platforms, and receive royalties on such licenses. We also outsource
some of our product development activities to third party developers,
contractually retaining all intellectual property rights related to such
projects. We also license certain products developed by third parties and pay
royalties on such products. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Dependence on Third Party
Software Developers."
We regard our software as proprietary and rely primarily on a combination
of patent, copyright, trademark and trade secret laws, employee and third party
nondisclosure agreements and other methods to protect our proprietary rights. We
own or license various copyrights and trademarks. While we provide "shrinkwrap"
license agreements or limitations on use with our software, the enforceability
of such agreements or limitations is uncertain. We are aware that unauthorized
copying occurs within the computer software industry, and if a significantly
greater amount of unauthorized copying of our interactive entertainment software
products were to occur, our operating results could be materially adversely
Page 10
affected. We use copy protection on selected products and do not provide source
code to third parties unless they have signed nondisclosure agreements.
We rely on existing copyright laws to prevent the unauthorized distribution
of our software. Existing copyright laws afford only limited protection.
Policing unauthorized use of our products is difficult, and we expect software
piracy to be a persistent problem, especially in certain international markets.
Further, the laws of certain countries in which our products are or may be
distributed either do not protect our products and intellectual property rights
to the same extent as the laws of the U.S. or are weakly enforced. Legal
protection of our rights may be ineffective in such countries, and as we
leverage our software products using emerging technologies, such as the Internet
and on-line services, our ability to protect our intellectual property rights,
and to avoid infringing the intellectual property rights of others, becomes more
difficult. In addition, the intellectual property laws are less clear with
respect to such emerging technologies. There can be no assurance that existing
intellectual property laws will provide our products with adequate protection in
connection with such emerging technologies.
As the number of software products in the interactive entertainment
software industry increases and the features and content of these products
further overlap, interactive entertainment software developers may increasingly
become subject to infringement claims. Although we take reasonable efforts to
ensure that its products do not violate the intellectual property rights of
others, there can be no assurance that claims of infringement will not be made.
Any such claims, with or without merit, can be time consuming and expensive to
defend. From time to time, we have received communications from third parties
asserting that features or content of certain of our products may infringe upon
such party's intellectual property rights. There can be no assurance that
existing or future infringement claims against us will not result in costly
litigation or require that we license the intellectual property rights of third
parties, either of which could have a material adverse effect on our business,
operating results and financial condition. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Factors Affecting
Future Performance--Protection of Proprietary Rights."
EMPLOYEES
As of December 31, 2001, we had 277 employees, including 190 in product
development, 40 in sales and marketing and 47 in finance, general and
administrative. Included in these counts are 36 employees of Shiny, 16 employees
of Interplay OEM and 2 employees of Interplay UK. We also retain independent
contractors to provide certain services, primarily in connection with our
product development activities. Neither we nor our full time employees are
subject to any collective bargaining agreements and we believe that our
relations with our employees are good.
From time to time, we have retained actors and/or "voice over" talent to
perform in certain of our products, and we expect to continue this practice in
the future. These performers are typically members of the Screen Actors Guild
("SAG") or other performers' guilds, which guilds have established collective
bargaining agreements governing their members' participation in interactive
media projects. We may be required to become subject to one or more of these
collective bargaining agreements in order to engage the services of these
performers in connection with future development projects.
ITEM 2. PROPERTIES
Our headquarters are located in Irvine, California, where we lease
approximately 81,000 square feet of office space. This lease expires in June
2006 and provides us with one five year option to extend the term of the lease
and expansion rights, on an "as available basis," to approximately double the
size of the office space. We lease approximately 10,000 square feet of space in
Buckinghamshire, England. This lease expires in October 2014 and, we have the
option for early termination of the lease in November 2005. In addition, we rent
approximately 1,700 square feet of office space in Central London, England from
Virgin. This agreement is on a quarter by quarter basis. We lease approximately
4,100 square feet of space in Laguna Beach, California, which lease expires in
October 2002. We believe that our facilities are
adequate for our current needs and that suitable additional or substitute space
will be available in the future to accommodate potential expansion of our
operations.
Page 11
ITEM 3. LEGAL PROCEEDINGS
The Company is occasionally involved in various legal proceedings, claims
and litigation arising in the ordinary course of business, including disputes
arising over the ownership of intellectual property rights and collection
matters. In the opinion of management, the outcome of such routine claims will
not have a material adverse effect on the Company's business, financial
condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is traded on The NASDAQ Stock Market National Market
System under the symbol "IPLY". At December 31, 2001, there were 98 holders of
record of our common stock.
The following table sets forth the range of high and low sales prices for
our common stock for the periods indicated.
FOR THE YEAR ENDED DECEMBER 31, 2001 HIGH LOW
------------------------------------ ---- ---
First Quarter................................ $3.25 $1.50
Second Quarter............................... 3.11 1.33
Third Quarter................................ 2.20 0.33
Fourth Quarter............................... 0.96 0.31
FOR THE YEAR ENDED DECEMBER 31, 2000 HIGH LOW
------------------------------------ ---- ---
First Quarter................................ $4.50 $2.91
Second Quarter............................... 3.31 1.75
Third Quarter................................ 3.81 2.25
Fourth Quarter............................... 4.00 2.56
DIVIDEND POLICY
We have never paid any dividends on our common stock. We intend to retain
any earnings for use in our business and do not intend to pay any cash dividends
on our common stock in the foreseeable future.
Page 12
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated statements of operations data for the years ended
December 31, 2001, 2000 and 1999 and the selected consolidated balance sheets
data as of December 31, 2001 and 2000 are derived from our audited consolidated
financial statements included elsewhere in this Form 10-K. The selected
consolidated statements of operations data for the year ended December 31, 1998,
the eight months ended December 31, 1997 and for the year ended April 30, 1997,
and the selected consolidated balance sheets data as of December 31, 1999, 1998,
1997 and April 30, 1997 are derived from our audited consolidated financial
statements not included in this Form 10-K. Our historical results are not
necessarily indicative of the results that may be achieved for any other period.
The following data should be read in conjunction with "Management's Discussion
and Analysis of Financial Condition and Results of Operations" and the
Consolidated Financial Statements included elsewhere in this Form 10-K.
EIGHT MONTHS
ENDED YEAR ENDED
YEARS ENDED DECEMBER 31, DECEMBER 31, APRIL 30,
----------------------------------------------------- --------------- -------------
2001 2000 1999 1998 1997(1) 1997
------------ ------------ ------------ ------------- --------------- -------------
(Dollars in thousands, except per share amounts)
STATEMENTS OF OPERATIONS DATA:
Net revenues $ 57,789 $ 104,582 $ 101,930 $ 126,862 $ 85,961 $ 83,262
Cost of goods sold 45,816 54,061 61,103 71,928 44,864 62,480
------------ ------------ ------------ ------------ ------------ ------------
Gross profit 11,973 50,521 40,827 54,934 41,097 20,782
Operating expenses:
Marketing and sales 20,038 26,482 32,432 39,471 20,603 24,627
General and administrative 12,622 10,249 18,155 12,841 8,989 9,408
Product development 20,603 22,176 20,629 24,472 14,291 21,431
Other - 2,415 - - -
------------ ------------ ------------ ------------ ------------ ------------
Total operating expenses 53,263 58,907 73,631 76,784 43,883 55,466
------------ ------------ ------------ ------------ ------------ ------------
Operating loss (41,290) (8,386) (32,804) (21,850) (2,786) (34,684)
Other expense (4,526) (3,689) (3,471) (4,933) (2,273) (1,600)
------------ ------------ ------------ ------------ ------------ ------------
Loss before income taxes (45,816) (12,075) (36,275) (26,783) (5,059) (36,284)
Provision (benefit) for income taxes 500 - 5,410 1,437 - (9,065)
------------ ------------ ------------ ------------ ------------ ------------
Net loss $ (46,316) $ (12,075) $ (41,685) $ (28,220) $ (5,059) $ (27,219)
------------ ------------ ------------ ------------ ------------ ------------
Cumulative dividend on participating
preferred stock $ 966 $ 870 $ - $ - $ - $ -
Accretion of warrant 266 532 - - - -
------------ ------------ ------------ ------------ ------------ ------------
Net loss available to common
stockholders $ (47,548) $ (13,477) $ (41,685) $ (28,220) $ (5,059) $ (27,219)
============ ============ ============ ============ ============ ============
Net loss per common share:
Basic/diluted $ (1.23) $ (0.45) $ (1.86) $ (1.91) $ (0.45) $ (2.46)
Shares used in calculating net loss
per common share 38,670,343 30,046,701 22,418,463 14,762,644 11,123,327 11,085,632
SELECTED OPERATING DATA:
Net revenues by geographic region:
North America $ 36,339 $ 56,454 $ 49,443 $ 73,865 $ 51,833 $ 38,606
International 15,451 35,077 30,310 35,793 24,642 32,006
OEM, royalty and licensing 5,999 13,051 22,177 17,204 9,486 12,650
Net revenues by platform:
Personal computer $ 36,253 $ 76,886 $ 65,397 $ 67,406 $ 42,520 $ 45,192
Video game console 15,537 14,645 14,356 42,252 33,955 25,420
OEM, royalty and licensing 5,999 13,051 22,177 17,204 9,486 12,650
DECEMBER 31, APRIL 30,
------------------------------------------------------------------------ ------------
2001 2000 1999 1998 1997 1997
------------ ------------ ------------ ------------ ------------ ------------
Balance Sheets Data: (Dollars in thousands)
Working capital $ (34,169) $ 123 $ (7,622) $ (3,135) $ 13,616 $ 7,890
Total assets 31,106 59,081 56,936 74,944 77,821 69,005
Total debt 4,794 25,433 19,630 24,651 38,154 14,970
Stockholders' equity (deficit) (28,150) 6,398 (2,071) 4,193 (1,267) 3,401
(1) Effective May 1, 1997, the Company changed its year end from April 30 to
December 31.
Page 13
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
You should read the following discussion and analysis in conjunction with
the Consolidated Financial Statements and notes thereto and other information
included or incorporated by reference herein.
GENERAL
We derive net revenues primarily from sales of software products to
distributors in North America and internationally, and from sales of software
products to end-users through our catalogs and the Internet. We also derive
royalty-based revenues from licensing arrangements, from the sale of products by
third party distributors in North America and international markets, and from
original equipment manufacturing, or OEM bundling transactions.
In order to expand our distribution channels and engage in software
development in overseas markets, in 1995 we established operations in the United
Kingdom and in 1997, we initiated a licensing strategy in Japan. In February
1999, we undertook a restructuring of our operations in the United Kingdom that
included our investment in VIE Acquisition Group LLC, or VIE. In connection with
our investment in VIE, we entered into an exclusive distribution agreement with
Virgin Interactive Entertainment Limited, or Virgin, an entity controlled by
VIE, and integrated our distribution operations with Virgin. This substantially
reduced our sales and marketing personnel in Europe. As part of our April 2001
settlement with Virgin, VIE redeemed our equity interest in the company and we
agreed to assume responsibility for marketing functions in Europe for our
products. We also maintain European OEM and product development operations.
International net revenues accounted for approximately 27 percent of our net
revenues for the year ended December 31, 2001, 34 percent of our net revenues
for the year ended December 31, 2000, and 30 percent of our net revenues for the
year ended December 31, 1999.
In August 2001, we entered into a distribution agreement with Vivendi
Universal Games, Inc., formerly known as Vivendi Universal Interactive
Publishing North America, Inc. (the parent company of Universal Studios, Inc.,
who as of today owns approximately 5 percent of our common stock) providing for
Vivendi to become our distributor in North America through December 31, 2003 for
substantially all of our products, with the exception of products with
pre-existing distribution agreements. OEM rights were not among the rights
granted to Vivendi under the distribution agreement. Under the terms of the
agreement, as amended, Vivendi earns a distribution fee based on the net
sales of the titles distributed. Under the agreement, as amended, Vivendi made
four advance payments to us totaling $13.5 million. Vivendi will recoup these
advances from future sales of our products, which will reduce our future cash
receipts from Vivendi. In an effort to minimize the number of product returns
following the transition of our North America distribution to Vivendi, we
granted large price concessions to resellers on products in their inventory. As
a consequence, we substantially increased our sales allowances from 19 percent
of our total accounts receivable in 2000 to 44 percent of our total accounts
receivable in 2001.
As a result of engaging Vivendi as our North America distributor, we now
distribute substantially all of our products through distributors. We have
therefore substantially discontinued our internal product distribution capacity,
including our sales and marketing capacity. Following this change, we have
re-oriented our business towards product development and publishing. In October
2001, we reduced our headcount by approximately 15 percent, which included the
elimination of redundant positions resulting from the distribution agreement.
Our wholly-owned subsidiary, Interplay OEM, distributes our interactive
entertainment software titles, as well as those of other software publishers, to
computer and peripheral device manufacturers for use in bundling arrangements.
Additionally, in 2000 Interplay OEM created a division named bundledirect.com,
which sold fixed bundle packs to Value-Added Resellers and system builders.
Bundledirect.com did not meet our expectations and, as a result, was disbanded
in 2001. Our results of operations were not materially impacted by the creation
or disbanding of Bundledirect.com. We also derive net revenues from the
licensing of intellectual property and products to third parties for
distribution in markets and through channels that are outside of our primary
focus. OEM, royalty and licensing net revenues collectively accounted for 10
percent of net revenues for the year ended December 31, 2001, 12 percent for the
year ended December 31, 2000, and 22 percent for the year ended December 31,
1999. OEM, royalty and licensing net revenues generally are incremental net
revenues and do not have significant additional product development or sales and
marketing costs.
Page 14
Cost of goods sold related to PC and video game console net revenues
represents the manufacturing and related costs of interactive entertainment
software products, including costs of media, manuals, duplication, packaging
materials, assembly, freight and royalties paid to developers, licensors and
hardware manufacturers. Cost of goods sold related to royalty-based net revenues
primarily represents third party licensing fees and royalties paid by us.
Typically, cost of goods sold as a percentage of net revenues for video game
console products and affiliate label products are higher than cost of goods sold
as a percentage of net revenues for PC based products due to the relatively
higher manufacturing and royalty costs associated with video game console and
affiliate label products. We also include in the cost of goods sold amortization
of prepaid royalty and license fees we pay to third party software developers.
We expense prepaid royalties over a period of six months commencing with the
initial shipment of the title at a rate based upon the numbers of units shipped.
We evaluate the likelihood of future realization of prepaid royalties and
license fees quarterly, on a product-by-product basis, and charge the cost of
goods sold for any amounts that we deem unlikely to realize through future
product sales.
For the year ended December 31, 2001, our net loss was $46.3 million. Our
results from operations were adversely affected by several factors. We incurred
$8.1 million of non-recurring write-offs of prepaid royalties relating to titles
that had been canceled mainly due to discontinued projects that did not meet our
desired profit requirements. Our returns represented a higher percentage of
sales due to the price concessions we granted in connection with the North
America Distribution Agreement we entered into with Vivendi. The termination of
our bank line of credit had a negative affect on our capital resources and as a
result we had to implement cost reduction programs, which delayed the release
of certain titles and caused the sale of a title in development to a third party
publisher resulting from a dispute with a third party developer. Furthermore, we
have had to delay payments to vendors, which has negatively impacted our
relations with our vendors, but has not affected our operations, as our
distributors Vivendi and Virgin are responsible for our manufacturing and
marketing expenditures. We have been able to retain our third party developers
to date, but if our current liquidity issues continue, our future title
development could be adversely affected. As a result of these factors, we
experienced lower unit sales volume than we expected in 2001. We expect our unit
sales volumes on next generation video console platforms to increase and our
unit sales volume on personal computer platforms to decrease in the 12 months
ending December 31, 2002 as compared to the same period in 2001 as we focus more
on next generation video game console titles.
Our operating results have fluctuated significantly in the past and likely
will fluctuate significantly in the future, both on a quarterly and an annual
basis. A number of factors may cause or contribute to such fluctuations, and
many of such factors are beyond our control. We cannot assure you that we will
be profitable in any particular period. It is likely that our operating results
in one or more future periods will fail to meet or exceed the expectations of
securities analysts or investors. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Factors Affecting Future
Performance - Fluctuations in Operating Results; Uncertainty of Future Results;
Seasonality."
Our operating results will continue to be impacted by economic, industry
and business trends affecting the interactive entertainment industry. Our
industry is highly seasonal, with the highest levels of consumer demand
occurring during the year-end holiday buying season. With the release of next
generation console systems by Sony, Nintendo and Microsoft, our industry has
entered into a growth period that could be sustained for the next couple of
years.
The accompanying consolidated financial statements have been prepared
assuming that we will continue as a going concern, which contemplates the
realization of assets and the satisfaction of liabilities in the normal course
of business. The carrying amounts of assets and liabilities presented in the
financial statements do not purport to represent realizable or settlement
values. The Report of our Independent Auditors for the December 31, 2001
consolidated financial statements includes an explanatory paragraph expressing
substantial doubt about our ability to continue as a going concern.
MANAGEMENT'S DISCUSSION OF CRITICAL ACCOUNTING POLICIES
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-
Page 15
going basis, we evaluate our estimates, including those related to revenue
recognition, prepaid licenses and royalties and software development costs. We
base our estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ from these estimates under different assumptions or conditions. We
believe the following critical accounting policies affect our more significant
judgments and estimates used in preparation of our consolidated financial
statements.
REVENUE RECOGNITION
We record revenues when we deliver products to customers in accordance with
Statement of Position ("SOP") 97-2, "Software Revenue Recognition." and SEC
Staff Accounting Bulletin No. 101, Revenue Recognition. With the signing of the
Vivendi distribution agreement in August 2001, substantially all of our sales
are made by two related party distributors. The Company recognizes revenue from
sales by distributors, net of sales commissions, only as the distributor
recognizes sales of the Company's products to unaffiliated third parties. For
those agreements that provide the customers the right to multiple copies of a
product in exchange for guaranteed amounts, we recognize revenue at the delivery
of the product master or the first copy. We recognize per copy royalties on
sales that exceed the guarantee as copies are duplicated. We generally are not
contractually obligated to accept returns, except for defective, shelf-worn and
damaged products. However, on a case-by-case negotiated basis, we permit
customers to return or exchange product and may provide price concessions to our
retail distribution customers on unsold or slow moving products. In accordance
with Statement of Financial Accounting Standards ("SFAS") No. 48, "Revenue
Recognition when Right of Return Exists," we record revenue net of a provision
for estimated returns, exchanges, markdowns, price concessions, and warranty
costs. We record such reserves based upon management's evaluation of historical
experience, current industry trends and estimated costs. During 2001, we
substantially increased our sales allowances as a result of the granting of
price concessions to resellers on products in their inventory, in an effort to
minimize product returns following the transition of our North American
distribution rights to Vivendi. As a result, sales allowances as a percentage of
our total accounts receivable increased to 44 percent at December 31, 2001 from
19 percent at December 31, 2000. The amount of reserves ultimately required
could differ materially in the near term from the amounts provided in the
accompanying consolidated financial statements. We provide customer support only
via telephone and the Internet. Customer support costs are not material and we
charge such costs to expenses as we incur them.
PREPAID LICENSES AND ROYALTIES
Prepaid licenses and royalties consist of license fees paid to intellectual
property rights holders for use of their trademarks or copyrights. Also included
in prepaid royalties are prepayments made to independent software developers
under developer arrangements that have alternative future uses. These payments
are contingent upon the successful completion of milestones, which generally
represent specific deliverables. Royalty advances are recoupable against future
sales based upon the contractual royalty rate. We amortize the cost of licenses,
prepaid royalties and other outside production costs to cost of goods sold over
six months commencing with the initial shipment in each region of the related
title. We amortize these amounts at a rate based upon the actual number of units
shipped with a minimum amortization of 75 percent in the first month of release
and a minimum of 5 percent for each of the next five months after release. This
minimum amortization rate reflects our typical product life cycle. Management
evaluates the future realization of such costs quarterly and charges to cost of
goods sold any amounts that management deems unlikely to be fully realized
through future sales. Such costs are classified as current and noncurrent assets
based upon estimated product release date.
SOFTWARE DEVELOPMENT COSTS
Our internal research and development costs, which consist primarily of
software development costs, are expensed as incurred. Statement of Financial
Accounting Standards ("SFAS") No. 86, "Accounting for the Cost of Computer
Software to be Sold, Leased, or Otherwise Marketed", provides for the
capitalization of certain software development costs incurred after
technological feasibility of the software is established or for development
costs that have alternative future uses. Under our current practice of
developing new products, the technological feasibility of the underlying
software is not established until substantially all of the product development
is complete. As a result, we have not capitalized any software development costs
on internal development projects, as the eligible costs were determined to be
insignificant.
Page 16
OTHER SIGNIFICANT ACCOUNTING POLICIES
Other significant accounting policies not involving the same level of
measurement uncertainties as those discussed above, are nevertheless important
to an understanding of the financial statements. The policies related to
consolidation and loss contingencies require difficult judgments on complex
matters that are often subject to multiple sources of authoritative guidance.
Certain of these matters are among topics currently under reexamination by
accounting standards setters and regulators. Although no specific conclusions
reached by these standard setters appear likely to cause a material change in
our accounting policies, outcomes cannot be predicted with confidence. Also see
Note 2 of Notes to Consolidated Financial Statements, Summary of Significant
Accounting Policies, which discusses accounting policies that must be selected
by management when there are acceptable alternatives.
RESULTS OF OPERATIONS
The following table sets forth certain consolidated statements of
operations data and segment and platform data for the periods indicated
expressed as a percentage of net revenues:
YEARS ENDED DECEMBER 31,
---------------------------------
2001 2000 1999
--------- -------- ---------
STATEMENTS OF OPERATIONS DATA:
Net revenues 100 % 100 % 100 %
Cost of goods sold 79 52 60
--------- -------- ---------
Gross margin 21 48 40
Operating expenses:
Marketing and sales 34 25 32
General and administrative 22 10 18
Product development 36 21 20
Other - - 2
--------- -------- ---------
Total operating expenses 92 56 72
--------- -------- ---------
Operating loss (71) (8) (32)
Other expense (8) (4) (4)
--------- -------- ---------
Loss before provision for income taxes (79) (12) (36)
Provision for income taxes 1 - 5
--------- -------- ---------
Net loss (80) % (12)% (41)%
========= ======== =========
SELECTED OPERATING DATA:
Net revenues by segment:
North America 63 % 54 % 48 %
International 27 34 30
OEM, royalty and licensing 10 12 22
--------- -------- --------
100 % 100 % 100 %
========= ======== ========
Net revenues by platform:
Personal computer 63 % 74 % 64 %
Video game console 27 14 14
OEM, royalty and licensing 10 12 22
--------- -------- --------
100 % 100 % 100 %
========= ======== ========
NORTH AMERICAN, INTERNATIONAL AND OEM, ROYALTY AND LICENSING NET REVENUES
Net revenues for the year ended December 31, 2001 were $57.8 million, a
decrease of 45 percent compared to the same period in 2000. This decrease
resulted from a 36 percent decrease in North American net revenues, a 56 percent
decrease in International net revenues and a 54 percent decrease in OEM,
royalties and licensing revenues. Our overall net revenues for the year ended
December 31, 2000 increased 3 percent compared to the same period in 1999. This
increase resulted from a 14 percent increase in North American net revenues and
a 16 percent increase in International net revenues, offset by a 41 percent
decrease in OEM, royalties and licensing.
Page 17
North American net revenues for the year ended December 31, 2001 were $36.3
million. The decrease in North American net revenues in 2001 was mainly due to
our release of only 8 titles in 2001 compared to 26 titles in 2000 resulting in
a decrease in North American sales of $21.6 million, partially offset by a
decrease in product returns and price concessions of $1.0 million as compared to
the 2000 period. The decrease in title releases across all platforms is a result
of our continued focus on product planning and the releasing of fewer, higher
quality titles. Our returns were a higher percentage of sales due primarily to
price concessions we granted in connection with the North American Distribution
Agreement we entered into with Vivendi.
International net revenues for the year ended December 31, 2001 were $15.5
million. The decrease in International net revenues for the year ended December
31, 2001 was mainly due to the reduction in title releases during the year which
resulted in a $17.4 million decrease in revenue and an increase in product
returns and price concessions of $1.8 million compared to the 2000 period. Our
product planning efforts during 2001 also contributed to the reduction of titles
released in the International markets. Furthermore, our returns as a percentage
of revenue, increased as we experienced a high level of product returns and
price concessions due to certain titles not gaining broad market acceptance.
We expect that both our North American and International publishing net
revenues in 2002 will increase compared to 2001, as we anticipate releasing more
major titles than in 2001.
North American net revenues were $56.5 million and International net
revenues were $35.1 million for the year ended December 31, 2000. The increase
in North American and International net revenues in 2000 was mainly because the
titles released this year generated $5.7 million more sales volume and because
of a decrease by $6.1 million in product returns and price concessions compared
to 1999. Our efforts to focus on product planning and release fewer, but higher
quality titles resulted in five fewer title releases across multiple platforms
in 2000 as compared to 1999.
OEM, royalty and licensing net revenues for the year ended December 31,
2001 were $6.0 million, a decrease of $7.1 million as compared to the same
period in 2000. The OEM business decreased $3.9 million as a result of general
market decreases in personal computer sales. The year ended December 31, 2000
also included $3 million of revenues related to a multi-product licensing
transaction with Titus Interactive S.A., our majority stockholder, which did not
recur in 2001. We expect that OEM, royalty and licensing net revenues in 2002
will increase compared to 2001 primarily related to the recording of $1.3
million in revenue resulting from the expiration of a licensing agreement
combined with a consistent level of OEM business.
OEM, royalty and licensing net revenues for the year ended December 31,
2000 were $13.1 million. The decrease in 2000 compared to the same period in
1999 was due to decreased net revenues in the OEM business and in licensing
transactions. The $5.1 million decrease in the OEM business was primarily due to
a decrease in the volume of transactions which relates to the general market
decrease in personal computer sales, and the decrease in licensing transactions
is primarily due to the recognition of $2.3 million of deferred revenue for the
shipment of a major title to a customer in 1999 without a comparable transaction
in 2000.
PLATFORM NET REVENUES
PC net revenues for the year ended December 31, 2001 were $36.3 million, a
decrease of 53 percent compared to the same period in 2000. The decrease in PC
net revenues in 2001 was primarily due to the release of three major hit titles
in 2001 (Icewind Dale: Heart of Winter, Fallout Tactics and Baldur's Gate II:
Throne of Bhaal), as compared to seven major hit titles released in 2000. The
decrease in PC net revenues was further affected by releasing only a total of 7
titles in 2001 compared to a total of 18 titles in 2000. We expect our PC net
revenues to decrease in 2002 as compared to 2001 as we expect to release only
two to three new titles and as we continue to focus on next generation console
titles. Video game console net revenues increased 6 percent for the year ended
December 31, 2001 compared to the same period in 2000, due to sales generated
from the release of Baldur's Gate: Dark Alliance (PlayStation 2). Our other
video game releases include MDK 2: Armageddon (PlayStation 2) and Giants
(PlayStation 2). In 2001, our 3 title releases were developed for next
generation video game consoles and as a result price points for the 2001
releases were higher than the 4 title releases in 2000. We anticipate releasing
four to eight new titles in 2002 and expect net revenues to increase in 2002
partly due to the fact that we anticipate releasing sequels to the major title
release Baldur's Gate: Dark Alliance (PlayStation 2) on Xbox and Gamecube in the
latter half of 2002.
Page 18
PC net revenues for the year ended December 31, 2000 increased 18 percent
to $76.9 million as compared to the same period in 1999 primarily due to the
release of seven major hit titles such as Star Trek Klingon Academy, Icewind
Dale, Sacrifice, Baldur's Gate II, Giants, Star Trek StarFleet Command II and
Star Trek New Worlds, compared to six major hit titles released in 1999. In
addition, we continue to experience strong sales from Baldur's Gate and Baldur's
Gate: Tales of the Sword Coast, both of which were released prior to 2000. The
increase in PC net revenues was partially offset by our release of 18 titles in
2000 compared to 28 titles in 1999. Video game console net revenues increased 2
percent in the year ended December 31, 2000 compared to the same period in 1999,
due to higher unit sales of our major console title releases, partially offset
by approximately 10 percent lower price points for current generation console
titles. We released four major video game console titles in 2000, including MDK
2 (Dreamcast), Gekido (PlayStation), Caesar's Palace 2000 (PlayStation) and Wild
Wild Racing (PlayStation 2), compared to three major video game console titles
released in 1999.
COST OF GOODS SOLD; GROSS MARGIN
Our cost of goods sold decreased 15 percent to $45.8 million in the year
ended December 31, 2001 compared to the same period in 2000. Furthermore, we
incurred $8.1 million of non-recurring charges related to the write-off of
prepaid royalties on titles that we decided to cancel because these titles were
not expected to meet our desired profit requirements. We expect our cost of
goods sold to increase in 2002 as compared to 2001 due to our expected higher
gross revenues from the planned release of more titles in 2002. Our gross margin
decreased to 21 percent for 2001 from 48 percent in 2000. This was due to an
increase in our royalty expense as a result of the $8.1 million write-off of
prepaid royalties, an increase in our product cost of goods due to our increase
in video game console title sales, which typically have a higher per unit cost,
and an increase in our product returns and price concessions as compared to
2000. We expect our gross profit margin and gross profit to increase in 2002 as
compared to 2001 as we expect not to incur any unusual product returns and price
concessions or any write-offs of prepaid royalties in 2002.
Cost of goods sold decreased to $54.1 million, a 12 percent decrease, in
the year ended December 31, 2000 compared to the same period in 1999, due to
releasing a higher percentage of internally developed titles and the
discontinuation of the affiliate label distribution business that typically has
a higher cost of goods component relative to net sales. The 1999 period also
reflects $1.7 million of non-recurring charges related to the write-off of
prepaid royalties on titles that had been canceled mainly due to our
discontinuation of our licensed sports product line during 1999. The 24 percent
increase in gross profit was primarily due to a 33 percent increase in
internally developed titles sold without a royalty component in cost of goods
sold, and a 25 percent decrease in product returns and price concessions
compared to the 1999 period.
MARKETING AND SALES
Marketing and sales expenses primarily consist of advertising and retail
marketing support, sales commissions, marketing and sales personnel, customer
support services and other related operating expenses. Marketing and sales
expenses for the year ended December 31, 2001 were $20.0 million, a 24 percent
decrease as compared to the 2000 period. The decrease in marketing and sales
expenses is due to a $5.7 million reduction in advertising and retail marketing
support expenditures due to fewer product releases in 2001 and a $2.0 million
decrease in personnel costs and general expenses due in part to our shift from a
direct sales force for North America to a distribution arrangement with Vivendi.
The decrease in marketing and sales expenses was partially offset by $1.3
million in overhead fees paid to Virgin under our April 2001 settlement with
Virgin (See Activities with Related Parties). We expect our marketing and sales
expenses to decrease in 2002 compared to 2001, due to fewer overall planned
title releases in 2002 across all platforms, lower personnel costs due to our
reduced headcount and a reduction in overhead fees paid to Virgin pursuant to
the April 2001 settlement.
Marketing and sales expenses for the year ended December 31, 2000 were
$26.5 million. The 18 percent decrease in marketing and sales expenses for 2000
compared to the 1999 period is attributable primarily to $2.9 million for
minimum operating charges payable to Virgin which did not repeat in 2000, a $1.3
million decrease in personnel costs and a $0.5 million decrease in advertising
and retail marketing support expenditures. In addition, we amended our
International Distribution Agreement with Virgin effective January 1, 2000,
which eliminated the fixed monthly overhead fees of approximately $2.3 million
we incurred in the 1999 period.
Page 19
GENERAL AND ADMINISTRATIVE
General and administrative expenses primarily consist of administrative
personnel expenses, facilities costs, professional fees, bad debt expenses and
other related operating expenses. General and administrative expenses for the
year ended December 31, 2001 were $12.6 million, a 23 percent increase as
compared to the same period in 2000. The increase is due in part to a $0.7
million provision for the termination of a building lease in the United Kingdom,
$0.1 million increase in the provision for bad debt, $0.5 million in legal,
accounting and investment banking fees and expenses incurred principally in
connection with efforts to sell the company which has been terminated, $0.5
million in consulting expenses payable to Titus, incurred to assist us with the
restructuring of the company and $0.6 million increase in personnel costs and
general expenses. We expect our general and administrative expenses to decrease
slightly in 2002 compared to 2001 primarily due to the reduction in head count.
The 44 percent decrease in general and administrative expenses to $10.2
million for the year ended December 31, 2000 compared to the same period in 1999
is primarily attributable to a $6.6 million decrease in bad debt expense and a
$1.1 million decrease in personnel costs.
PRODUCT DEVELOPMENT
We charge internal product development expenses, which consist primarily of
personnel and support costs, to operations in the period incurred. Product
development expenses for the year ended December 31, 2001 were $20.6 million, a
7 percent decrease as compared to the same period in 2000. This decrease is due
to a $1.7 million decrease in expenditures associated with resources dedicated
to completing four major internally developed titles in the 2000 period, which
did not recur in the 2001 period as well as a reduction in headcount. We expect
our product development expenses to decrease in 2002 compared to 2001 as we plan
on releasing fewer titles in 2002.
Product development expenses for the year ended December 31, 2000 were
$22.2 million, a 7 percent increase as compared to the same period in 1999 is
due to a $1.5 million increase in expenditures devoted to our focus on
developing next generation video game console platforms.
OTHER OPERATING EXPENSE
In 1999, we discontinued our direct and then existing affiliate
distribution activities in Europe and appointed Virgin as our exclusive
distributor in Europe. In connection with our exiting direct and then existing
affiliated distribution activities, we restructured our operations by
terminating employees, closing facilities, retiring redundant assets, and
transitioning selected employees to the Virgin organization. We recorded a
provision of $2.4 million as restructuring expenses and costs associated with
the merger and integration of our European operations and the departure of two
members of senior management. We recorded costs associated with closing
facilities, related asset valuation issues, and costs associated with the
write-down of redundant equipment in the aggregate amount of $1.6 million and
severance and other employee related costs of $0.8 million. These amounts were
recorded as a charge to operating expenses, classified as other operating
expense on the consolidated statement of operations.
OTHER EXPENSE, NET
Other expense consists primarily of interest expense on our lines of credit
and foreign currency exchange transaction losses. Other expenses for the year
ended December 31, 2001 were $4.5 million, a 23 percent increase as compared to
the same period in 2000 was due to a $0.2 million expense associated with
foreign tax withholdings, $0.4 million in loan fees paid to our former bank
associated with the transition of our line of credit to a new bank, a $0.7
million in expense related to the issuance of a warrant to a former officer in
connection with his personal guarantee on our new line of credit and a $1.8
million penalty due to a delay in the effectiveness of a registration statement
in connection with our private placement of 8,126,770 shares of Common Stock,
offset by a $1.6 million decrease in interest expense related to lower net
borrowings on our line of credit and a $0.7 million decrease in losses
associated with foreign currency exchanges.
Other expense for the year ended December 31, 2000 was $3.7 million, a 6
percent increase as compared to the same period in 1999. The increase was due to
a $0.6 million decrease in interest expense on lower average borrowings under
Page 20
our line of credit, offset by a $0.7 million increase in foreign currency
exchange transaction losses incurred in connection with European distribution
activities.
PROVISION (BENEFIT) FOR INCOME TAXES
We recorded a tax provision of $0.5 million for the year ended December 31,
2001, compared with a tax provision of zero for the year ended December 31,
2000. The tax provision recorded during 2001 represents estimated tax
liabilities resulting from an Internal Revenue Service examination. We have a
deferred tax asset of approximately $56 million that has been fully reserved at
December 31, 2001. This tax asset would reduce future provisions for income
taxes and related tax liabilities when realized, subject to limitations.
We did not record a tax provision for the year ended December 31, 2000,
compared with a tax provision of $5.4 million for the year ended December 31,
1999. The tax provision recorded during 1999 represents an increase to the
valuation allowance on the deferred tax asset due to the uncertainty of
realization of the deferred tax asset in future periods.
LIQUIDITY AND CAPITAL RESOURCES
We have funded our operations to date primarily through the use of lines of
credit, royalty and distribution fee advances, cash generated by the private
sale of securities, proceeds of the initial public offering and from results of
operations. As of December 31, 2001, our principal resources included cash of
$119,000.
In April 2001, we secured a working capital line of credit from a bank
bearing interest at the bank's prime rate or LIBOR plus 2.5 percent. At December
31, 2001, borrowings under the new working capital line of credit bore interest
at 6.75 percent. Our line of credit provided for borrowings and letters of
credit of up to $15.0 million based in part upon qualifying receivables and
inventory. Under the line of credit, we are required to maintain a $2.0 million
personal guarantee by our former Chairman, secured by $1 million in cash. The
line of credit had a term of three years, subject to review and renewal by the
bank on April 30 of each subsequent year.
At September 30, 2001, we were not in compliance with some of the covenants
under the line of credit. On October 26, 2001, the bank notified us that the
credit agreement was being terminated, that all related amounts outstanding were
due and payable and that we would no longer be able to continue to draw on the
credit facility to fund future operations. Because we depend on a credit
facility to fund our operations, the bank's termination of the credit agreement
had, and continues to have a material adverse effect on our business. At
December 31, 2001, $1.6 million was outstanding on the line of credit. In
February 2002, the bank drew-down on $1.0 million of the $2.0 million personal
guarantee provided by our former Chairman, which in combination with cash paid
by the Company, substantially paid off the remaining outstanding balance on the
line of credit. In March 2002, the Company entered into a forbearance agreement
with the bank and its former Chairman, and subsequent to that agreement repaid
all remaining amounts due the bank under the line of credit, and agreed to repay
its former Chairman for the $1.0 million paid to the bank pursuant to the former
Chairman's guarantee.
In April 2001, we completed a private placement of 8,126,770 units
consisting of one share of common stock and one warrant to purchase an
additional share of common stock for $12.7 million, and received net proceeds of
approximately $11.7 million. The units were issued at $1.5625 per share. The
warrants are exercisable at $1.75 per share, and the warrants can be exercised
immediately. The warrants expire in March 2006. The transaction provided for a
registration statement covering the shares sold or issuable upon exercise of
such warrants to be filed by April 16, 2001 and become effective by May 31,
2001. In the event that the agreed effective date of the registration statement
was not met, we are subject to a penalty of approximately $254,000 per month,
payable in cash, until the registration statement is effective. We did not meet
the effective date of the registration statement and as of the date of this
filing, the registration statement has not yet been declared effective. This
obligation will continue to accrue each month that the registration statement is
not declared effective until the registration becomes effective or shares fall
under rule 144(K), which would go into effect on April 16, 2003. Because this
payment is cumulative, this obligation could have a material adverse effect on
our consolidated financial condition and results of operations. As of December
31, 2001, the amount accrued was $1.8 million. We may be unable to pay the total
penalty due to the investors.
Page 21
In April 2001, the Chairman provided us with a $3.0 million loan, payable
in May 2002, with interest at 10 percent. In connection with this loan and the
$2.0 million personal guarantee he provided under the new line of credit from a
bank, the Chairman received warrants to purchase 500,000 shares of our common
stock at $1.75 per share, which vested upon issuance, expiring in April 2004.
Our primary capital needs have historically been to fund working capital
requirements necessary to fund our net losses, our sales growth, the development
and introduction of products and related technologies and the acquisition or
lease of equipment and other assets used in the product development process. Our
operating activities provided cash of $8.1 million during the year ended
December 31, 2001, primarily attributable to collections of accounts receivable,
advances from distribution agreements and an increase in accounts payable due to
delays in payments to vendors, substantially offset by the net loss for the year
and payments of royalty liabilities. Net cash used by financing activities of
$9.0 million for the year ended December 31, 2001, consisted primarily of
repayments of our previous line of credit and supplemental line of credit from
Titus offset by the proceeds from the private placement of 8,126,770 shares of
our common stock, an advance for the development of future titles on a next
generation video game console, borrowings under our new working capital line of
credit and borrowings under a loan payable to our Chairman. Cash used in
investing activities of $1.8 million for the year ended December 31, 2001
consisted of normal capital expenditures, primarily for office and computer
equipment used in our operations. We do not currently have any material
commitments with respect to any future capital expenditures.
The following summarizes our contractual obligations at December 31, 2001,
and the effect such obligations are expected to have on our liquidity and cash
flow in future periods.
Less Than 1 - 3 After
December 31, 2001 Total 1 Year Years 3 Years
---------- ---------- --------- ---------
(In thousands)
Contractual cash obligations:
Line of credit $ 1,576 $ 1,576 $ - $ -
Other borrowings 3,218 3,218 - -
Non-cancelable operating
lease obligations 7,992 1,835 3,665 2,492
--------- -------- -------- --------
Total contractual cash obligations $ 12,786 $ 6,629 $ 3,665 $ 2,492
========= ======== ======== ========
During the last six months of 2001, we have not released sufficient
products to generate a profitable level of revenues, or sufficient accounts
receivable to obtain an alternative to our terminated credit line. We also
anticipate that delays in product releases could continue in the short-term, and
funds available from ongoing operations will not be sufficient to satisfy our
projected working capital and capital expenditure requirements.
As a result, we have implemented various measures including a reduction of
personnel, a reduction of fixed overhead commitments, cancellation or suspension
of development on future titles, which we believe do not meet sufficient
projected profit margins, and the scaling back of certain marketing programs. We
will continue to pursue various alternatives to improve future operating
results, including strategic alliances such as the distribution agreement with
Vivendi and further expense reductions, some of which may have a long-term
adverse impact on our ability to generate successful future business activities.
In addition, we continue to seek external sources of funding, including but not
limited to, a sale or merger of the company, a private placement of our capital
stock, the sale of selected assets, the licensing of certain product rights in
selected territories, selected distribution agreements, and/or other strategic
transactions sufficient to provide short-term funding, and potentially achieve
our long-term strategic objectives.
We are currently in the advanced stages of negotiation with a potential
buyer of our product development subsidiary, Shiny Entertainment, Inc. If this
sale is consummated, we believe that the proceeds from the sale, following the
repayment of third party obligations, which are a condition to the transaction,
should fund our operations at least through the end of 2002.
However, there is no assurance that we will be able to complete the sale of
Shiny, or that the net proceeds from the sale will be sufficient to fund our
operations through December 31, 2002. Furthermore, if we are unable to complete
the
Page 22
sale of Shiny, we will not have sufficient funds to repay our outstanding
liabilities, and no assurances can be given that alternative sources of funding
could be obtained on acceptable terms to us, or at all. These conditions,
combined with our historical operating losses and our deficits in stockholders'
equity and working capital, raise substantial doubt about our ability to
continue as a going concern. The accompanying consolidated financial statements
do not include any adjustments to reflect the possible future effects on the
recoverability and classification of assets and liabilities that may result from
the outcome of this uncertainty.
ACTIVITIES WITH RELATED PARTIES
Our operations involve significant transactions with Titus, our majority
stockholder, Virgin, a wholly-owned subsidiary of Titus, and Vivendi, an owner
of 5 percent of our common stock. In addition, we obtained financing from the
former Chairman of the company.
TRANSACTIONS WITH TITUS
In March 2002, Titus converted its remaining 383,354 shares of Series A
preferred stock into approximately 47.5 million shares of our common stock.
Titus now owns approximately 67 million shares of common stock, which represents
approximately 72% of our outstanding common stock, our only voting security,
immediately following the conversion.
In September 2001, Titus retained Europlay as consultants to assist with
the restructuring of the company. Because the arrangement with Europlay is with
Titus and Europlay's services have a direct benefit to us, we recorded an
expense and a capital contribution by Titus of $75,000 for the year ended
December 31, 2001 in accordance with the SEC's Staff Accounting Bulletin No. 79
"Accounting for Expenses and Liabilities Paid by Principal Stockholders." In
December 2001, we agreed to reimburse Titus for consulting expenses incurred on
our behalf since October 2001. As of December 31, 2001, we owed Titus $450,000
as a result of this arrangement. We have also entered into a commission-based
agreement with Europlay where Europlay will assist us with strategic
transactions, such as debt or equity financing, the sale of assets or an
acquisition of the company.
In connection with the equity investments by Titus, we perform distribution
services on behalf of Titus for a fee. In connection with such distribution
services, we recognized fee income of $21,000, $435,000 and $200,000 for the
years ended December 31, 2001, 2000 and 1999, respectively.
During the year ended December 31, 2000, we recognized $3 million in
licensing revenue under a multi-product license agreement with Titus for the
technology underlying one title and the content of three titles for multiple
game platforms, extended for a maximum period of twelve years, with variable
royalties payable to us from five to ten percent, as defined. We earned a $3
million non-refundable fully-recoupable advance against royalties upon signing
and completing all of our obligations under the agreement. During the year ended
December 31, 1999, we executed publishing agreements with Titus for three
titles. As a result of these agreements, we recognized revenue of $2.6 million
for delivery of these titles to Titus.
As of December 31, 2001 and 2000, Titus owed us $260,000 and $280,000,
respectively, and we owed Titus $1.3 million and $1.1 million, respectively.
Amounts due to Titus at December 31, 2001 include dividends payable of $740,000
and $450,000 for services rendered by Europlay. Amounts due to Titus at December
31, 2000 include borrowings of $1.0 million under the supplemental line of
credit. In March 2002, Titus paid the outstanding balance due to us.
TRANSACTIONS WITH VIRGIN, A WHOLLY OWNED SUBSIDIARY OF TITUS
In February 1999, we entered into an International Distribution Agreement
with Virgin, which provides for the exclusive distribution of substantially all
of our products in Europe, Commonwealth of Independent States, Africa and the
Middle East for a seven-year period, cancelable under certain conditions,
subject to termination penalties and costs. Under this agreement, we pay Virgin
a monthly overhead fee, certain minimum operating charges, a distribution fee
based on net sales, and Virgin provides certain market preparation, warehousing,
sales and fulfillment services on our behalf.
Page 23
We amended our International Distribution Agreement with Virgin effective
January 1, 2000. Under the amended Agreement, we no longer pay Virgin an
overhead fee or minimum commissions. In addition, we extended the term of the
agreement through February 2007 and implemented an incentive plan that will
allow Virgin to earn a higher commission rate, as defined. Virgin disputed the
amendment to the International Distribution Agreement with us, and claimed that
we were obligated, among other things, to pay for a portion of Virgin's overhead
of up to approximately $9.3 million annually, subject to decrease by the amount
of commissions earned by Virgin on its distribution of our products.
We settled this dispute with Virgin in April 2001 and further amended the
International Distribution Agreement and amended the Termination Agreement and
the Product Publishing Agreement, all of which were entered into on February 10,
1999 when we acquired an equity interest in VIE Acquisition Group LLC, the
parent entity of Virgin. As a result of the April 2001 settlement, Virgin
dismissed its claim for overhead fees, VIE fully redeemed our ownership interest
in VIE and Virgin paid us $3.1 million in net past due balances owed under the
International Distribution Agreement. In addition, we paid Virgin a one-time
marketing fee of $333,000 for the period ending June 30, 2001 and the monthly
overhead fee was revised for us to pay $111,000 per month for the nine month
period beginning April 2001, and $83,000 per month for the six month period
beginning January 2002, with no further overhead commitment for the remainder of
the term of the International Distribution Agreement. We no longer have an
equity interest in VIE or Virgin as of April 2001.
In connection with the International Distribution Agreement, we incurred
distribution commission expense of $2.3 million, $4.6 million and $3.4 million
for the years ended December 31, 2001, 2000 and 1999, respectively. In addition,
we recognized overhead fees of $1.0 million, zero and $3.9 million and certain
minimum operating charges to Virgin of $333,000, zero and $2.9 million for the
years ended December 31, 2001, 2000 and 1999, respectively.
We have also entered into a Product Publishing Agreement with Virgin, which
provides us with an exclusive license to publish and distribute substantially
all of Virgin's products within North America, Latin America and South America
for a royalty based on net sales. As part of terms of the April 2001 settlement
between Virgin and us, the Product Publishing Agreement was amended to provide
for us to publish only one future title developed by Virgin. In connection with
the Product Publishing Agreement with Virgin, we earned $36,000, $63,000 and
$41,000 for performing publishing and distribution services on behalf of Virgin
for the years ended December 31, 2001, 2000 and 1999, respectively.
In connection with the International Distribution Agreement, we sublease
office space from Virgin. Rent expense paid to Virgin was $104,000, $101,000 and
$50,000 for the years ended December 31, 2001, 2000 and 1999, respectively.
As of December 31, 2001 and 2000, Virgin owed us $7.5 million and $12.1
million, and we owed Virgin $5.8 million and $4.8 million, respectively.
TRANSACTIONS WITH VIVENDI
In August 2001, we entered into a distribution agreement with Vivendi (the
parent company of Universal Studios, Inc., which currently owns approximately 5
percent of our common stock at March 31, 2002 but does not have representation
on our Board of Directors) providing for Vivendi to become our distributor in
North America through December 31, 2003 for substantially all of our products,
with the exception of products with pre-existing distribution agreements. OEM
rights were not among the rights granted to Vivendi under the distribution
agreement. Under the terms of the agreement, as amended, Vivendi earns a
distribution fee based on the net sales of the titles distributed. Under the
agreement, Vivendi made four advance payments to us totaling $13.5 million.
Vivendi will recoup their advances from future sales of our products, which will
reduce our future cash in-flows. As of December 31, 2001, Vivendi has recouped
$3.4 million of the advance payments.
In connection with the distribution agreement with Vivendi, we incurred
distribution commission expense of $2.2 million for the year ended December 31,
2001. As of December 31, 2001, Vivendi owed us $2.4 million.
Page 24
TRANSACTIONS WITH A BRIAN FARGO, A FORMER OFFICER OF THE COMPANY
In connection with our working capital line of credit obtained in April
2001, we obtained a $2 million personal guarantee in favor of the bank, secured
by $1.0 million in cash, from Brian Fargo, the former Chairman of the company.
In addition, Mr. Fargo provided us with a $3 million loan, payable in May 2002,
with interest at 10 percent. In connection with the guarantee and loan, Mr.
Fargo received warrants to purchase 500,000 shares of our common stock at $1.75
per share, expiring in April 2011. In January 2002, the bank redeemed the $1.0
million in cash pledged by Mr. Fargo in connection with his personal guarantee,
and subsequently we agreed to pay that amount back to Mr. Fargo.
We had amounts due from a business controlled by Mr. Fargo. Net amounts
due, prior to reserves, at December 31, 2000 were $2.5 million. Such amounts at
December 31, 2000 are fully reserved. In 2001, we wrote off this receivable.
RECENT ACCOUNTING PRONOUNCEMENTS
On January 1, 2001, we adopted Statement of Financial Accounting Standards
("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities."
SFAS No. 133 establishes accounting and reporting standards for derivative
instruments. The statement requires that every derivative instrument be recorded
in the balance sheet as either an asset or liability measured at its fair value,
and that changes in the derivative's fair value be recognized currently in the
earnings unless specific hedge accounting criteria are met. The adoption of this
standard did not have a material impact on our consolidated financial position
or results of operations.
In December 1999, the Securities and Exchange Commission ("SEC") staff
released Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition," as
amended by SAB No. 101A and SAB No. 101B, to provide guidance on the
recognition, presentation and disclosure of revenue in financial statements. SAB
No. 101 explains the SEC staff's general framework for revenue recognition,
stating that certain criteria be met in order to recognize revenue. SAB No. 101
also addresses the question of gross versus net revenue presentation and
financial statement and Management's Discussion and Analysis disclosures related
to revenue recognition. We adopted SAB No. 101 effective January 1, 2000 and the
adoption of this standard reduced net sales and cost of sales by approximately
$1.7 million for the year ended December 31, 2000, but did not have an impact on
our gross profit or net loss. We did not apply this standard to the 1999 period
as the impact would have been immaterial to the financial statements taken as a
whole.
In March 2000, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 44, ("FIN 44"), Accounting for Certain Transactions Involving
Stock Compensation - an Interpretation of APB 25. This Interpretation clarifies
(a) the definition of employee for purposes of applying Opinion 25, (b) the
criteria for determining whether a plan qualifies as a non-compensatory plan,
(c) the accounting consequence of various modifications to the terms of a
previously fixed stock option or award, and (d) the accounting for an exchange
of stock compensation awards in a business combination. FIN 44 became effective
July 1, 2000, but certain conclusions in FIN 44 cover specific events that occur
after either December 15, 1998, or January 12, 2000. The adoption of FIN 44 did
not have a material effect on our consolidated financial position or results of
operations.
In April 2001, the Emerging Issues Task Force reached a consensus on Issue
No. 00-25 ("EITF 00-25"), "Accounting for Consideration from a Vendor to a
Retailer in Connection with the Purchase or Promotion of the Vendor's Products",
which requires that amounts paid by a vendor to a reseller of the vendor's
products is presumed to be a reduction of the selling prices of the vendor's
products and, therefore, should be characterized as a reduction of revenue when
recognized in the vendor's income statement. That presumption is overcome and
the consideration can be categorized as a cost incurred if, and to the extent
that, a benefit is or will be received from the recipient of the consideration.
That benefit must meet certain conditions described in EITF 00-25. We will adopt
the provisions of the consensus on January 1, 2002 and are currently evaluating
the impact of this consensus on our consolidated statement of
operations. Financial statements of prior periods will be conformed to the
presentation requirements of EITF 00-25 upon its adoption.
In June 2001, the FASB issued SFAS No. 141, "Business Combinations" and
SFAS No. 142, "Goodwill and Other Intangible Assets" Under the new rules, all
acquisition transactions entered into after June 30, 2001, must be accounted for
on the purchase method and goodwill will no longer be amortized but will be
subject to annual impairment tests in accordance with SFAS 142. Other intangible
assets will continue to be amortized over their useful lives. We will apply
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the new rules on accounting for goodwill and other intangible assets beginning
in the first quarter of 2002 and will perform the first of the required
impairment tests of goodwill as of January 1, 2002. We do not expect the
adoption of these statements to have a material effect on our consolidated
financial position or results of operations.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and the
accounting and reporting provisions of APB Opinion No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," for the disposal of a segment of a business (as previously
defined in that Opinion). We will adopt the provisions of SFAS No. 144 on
January 1, 2002, and do not expect the adoption to have a material impact on our
consolidated financial position or results of operations.
FACTORS THAT MAY AFFECT FINANCIAL CONDITION AND FUTURE RESULTS
Our financial condition and future operating results depend upon many
factors and are subject to various risks and uncertainties. Some risks and
uncertainties that may cause our operating results to vary from anticipated
results or which may materially and adversely affect our operating results are
as follows:
WE CURRENTLY HAVE A NUMBER OF OBLIGATIONS THAT WE ARE UNABLE TO MEET WITHOUT
GENERATING ADDITIONAL REVENUES OR RAISING ADDITIONAL CAPITAL. IF WE CANNOT
GENERATE ADDITIONAL REVENUES OR RAISE ADDITIONAL CAPITAL IN THE NEAR FUT