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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark one)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the fiscal year ended March 31, 2001 or
[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
Commission File Number: 72870
SONIC SOLUTIONS
(Exact name of registrant as specified in its charter)
California 93-0925818
(State or other jurisdiction of incorporation or (I.R.S. Employer Identification No.)
organization)
101 Rowland Way, Suite 110,
Novato, California 94945
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area
code: (415) 893-8000
Securities registered pursuant to Section 12(b)
of the Act: None
Securities registered pursuant to Section 12(g) Common Stock, no par
of the Act: value
(Title of class)
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.
The aggregate market value of the voting stock held by non-affiliates of
the registrant on May 31, 2001, based upon the closing price of the Common
Stock on the NASDAQ National Market for such date, was approximately
$ 14,302,636./1/
The number of outstanding shares of the registrant's Common Stock on May
31, 2001 was 13,510,703.
- -------
/1/ Excludes 2,068,594 shares held by directors, officers and ten percent or
greater shareholders on May 31, 2001. Exclusion of such shares should not be
construed to indicate that any such person possesses the power, direct or
indirect, to direct or cause the direction of the management or policies of
the registrant or that such person is controlled by or under common control
with the registrant.
Table of Contents
Page
----
PART I
ITEM 1. Business...................................................... 1
ITEM 2. Properties.................................................... 18
ITEM 3. Legal Proceedings............................................. 19
ITEM 4. Submission of Matters to a Vote of Security Holders........... 19
PART II
ITEM 5. Market for Registrant's Common Equity and Related Stockholder
Matters....................................................... 20
ITEM 6. Selected Financial Data....................................... 21
ITEM 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................... 22
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk.... 30
ITEM 8. Financial Statements and Supplementary Data................... 31
ITEM 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure...................................... 49
PART III
ITEM 10. Directors and Executive Officers of the Registrant............ 50
ITEM 11. Executive Compensation........................................ 53
ITEM 12. Security Ownership of Certain Beneficial Owners and
Management.................................................... 57
ITEM 13. Certain Relationships and Related Transactions................ 57
ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K........................................................... 58
Exhibits................................................................ 58
Signatures.............................................................. 62
(i)
Forward Looking Statements
This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934To the extent that this report discusses future financial
results, information or expectations about products or markets, or otherwise
makes statements about future events, such statements are forward-looking and
are subject to a number of risks and uncertainties that could cause actual
results to differ materially from the statements made. These risks and
uncertainties include, among others, the timely introduction and acceptance of
new products, costs associated with new product introductions, the transition
of products to new hardware configurations, and other factors. In addition,
such risks and uncertainties also include the matters identified under
Management's Discussion and Analysis of Financial Condition and Results of
Operations in Item 7 below.
PART I
Item 1. BUSINESS
Overview
We primarily develop, market and support workstations used by
professionals to edit and process digital audio and digital video information.
Our workstation products always include applications software and often include
plug-in hardware installed on a personal computer. Our customers use various
kinds of peripheral devices -- for example, disk drives, streaming tape drives,
audio and video tape recorders, and CD and DVD recorders -- along with our
products. Although we do not manufacture or sell the personal computer or
peripheral devices used with our products, we typically talk about the complete
configuration of personal computer, Sonic hardware, Sonic software, and
peripherals as a Sonic workstation.
We currently market two professional workstation product lines: DVD
Creator(TM) for DVD-Video production and SonicStudio(TM) for digital audio
production:
. DVD Creator is a line of DVD-Video production workstations that
supports the preparation and assembly of video and audio assets for
release in the DVD-Video format. We introduced DVD Creator in the
spring of 1996. In September 1999, we began shipments of a new line of
DVD-Video production workstations called DVD Fusion(TM). DVD Fusion,
which we consider to be part of the DVD Creator product line, is
intended to provide video producers and editors a lower priced set of
tools for preparing DVD-Video titles.
. SonicStudio is a line of professional audio workstations that our
customers use to prepare audio for release on Digital Audio Compact
Discs (CDs), for release with video and film entertainment, and for
broadcast on radio.
In February 2001 we acquired the professional DVD-Video authoring tools
business of Daikin Industries, Ltd. of Japan. The products acquired from Daikin
include Scenarist(TM), ReelDVD(TM) and some related products. Scenarist is a
software product intended for use by high-end video professionals in preparing
DVD-Video titles, particularly those titles intended for mass replication.
ReelDVD is a software product intended for use by corporate and "prosumer"
users in preparing DVD-Video titles for a range of applications. Roughly
speaking, Scenarist addresses the same target market as our DVD Creator
product, while ReelDVD addresses the same target market as our DVD Fusion
product.
In the past two years, we have started supplying software products outside
our traditional professional audio/video market. In September 1999, we began
shipping DVDit!(TM) a software product which provides simplified DVD authoring
capabilities to consumer, "prosumer," and some professional users. In the fall
of 2000 we introduced a simplified DVD-Video creation product called MyDVD,(TM)
which is intended for use by consumers. We believe there will be a strong
demand for this product because of the new generation of low cost DVD recording
devices that are being introduced to the personal computing market during 2001.
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Professional Products
Workstation Product Lines
We currently offer two professional workstation product lines, oriented
toward somewhat different applications within the professional audio and video
industry. DVD Creator is a line of DVD-Video/Audio production workstations.
SonicStudio is a line of professional digital audio workstations.
SonicStudio and most of our DVD Creator workstations are designed to run
on versions of the Macintosh personal computer manufactured by Apple Computer.
Current reliance on the Macintosh computer creates risks for our Company.
Please see the discussion under "Platforms; Platform Risk" at page 5, below.
Professional Video and Audio Industry
Customers
Our professional customers are mainly facilities that process and prepare
audio, video and film programming. Most of this programming is for
entertainment, though a significant portion of it is also used for educational
and business communications purposes.
Some of our professional customers are independent organizations that
supply services to audio and video content holders and publishers. Some of our
customers are in-house facilities that are owned by particular content holders
or publishers.
Our customers range in size from relatively small organizations with few
employees to larger facilities with hundreds of employees. Among our customers
are facilities that are independent, privately owned companies, as well as
facilities which are part of much larger public, private, or non-profit
organizations. While we have concluded corporate purchasing agreements with
certain customer organizations that have multiple facilities, even within such
organizations decisions to purchase and deploy our products are usually made at
the facility level.
Most of the time we market our professional products as Sonic Solutions
products, and not as part of another company's products. From time to time we
have concluded agreements with other companies in which they incorporate some
product of ours into their product line (this is commonly referred to as an
"OEM" arrangement). At the present time there is one such relationship that
accounts for a significant portion of our professional audio revenues. Please
see further discussion about this below under "OEM Customers; Sales
Concentration."
The Shift to Digital
The professional audio and video industry has shifted significantly from
analog to digital technology over the past twenty years. Digital technology
encodes sound and video as numbers and stores them as a kind of computer data.
In contrast, analog technology records sound and video by making a physical
representation analogous to the original audio or visual signal. Long-playing
records ("LP") and Digital Audio Compact Discs ("CD-A"), are good examples of
analog (LP's) and digital (CD-A's) media. In an LP the grooves cut into the
vinyl record have a physical shape analogous to the original sound pressure
wave. In a CD-A the original sound pressure wave is encoded into numbers that
are recorded as tiny pits on the surface of an optical disc.
The shift to digital encompasses the tools used to edit, process and
prepare audio and video prior to release, as well as audio and video release
formats -- the form in which the audio or video actually reaches the intended
consumer. Different applications and segments within the professional audio and
video industry have shifted to digital technology at different times. Complete
conversion to digital technology has not yet occurred. We expect that the shift
will continue for the next several years until some point toward the end of the
first
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decade of the 21st century when analog technology will effectively cease being
used in the professional audio and video industries.
There are a number of reasons why digital technology has been attractive
to audio and video professionals:
. Higher Quality -- Digital technology permits higher quality audio and
video to be recorded and replayed under most circumstances. Of course,
this assumes that the recordings involved are made at a high
resolution.
. Perfect Copying -- Digitally recorded audio and video can be perfectly
reproduced, over an unlimited number of generations. Every analog
recording process involves some amount of signal loss with each
successive generation of copying.
. Speed and Precision of Manipulation -- Digital technologies permit
more rapid and more accurate manipulation of audio and video signals
than is possible in analog technology.
. Special Capabilities -- Digital technology permits certain kinds of
processes that are difficult or practically impossible using analog
techniques. One of our own products, a signal processing tool called
NoNOISE, is a good example of this. NoNOISE permits audio recording
engineers to remove various kinds of noise from already recorded sound
with a great degree of precision and fidelity.
. Declining Costs -- Digital technology is enjoying dramatic cost
reductions, driven by the broad scale adoption and growth of computer
technology in business, in home use, in communications and on the
Internet. In contrast, analog technology for audio and video recording
has reached an effective plateau in terms of cost.
Of course, digital technologies have presented some drawbacks to adoption
over the past 20 years. A few of these are:
. Enormous Bandwidth -- Representing audio and video in high resolution
consumes a large amount of storage space and computer processing
power. Computers were historically first applied to text and
arithmetic processing applications which require relatively limited
digital storage and processing power. For example, a 300 page book-
length work can easily be represented in three megaBytes of storage. A
single CD-A requires some 600 megaBytes to store a little more than
one hour of stereo music.
. Real Time Requirements -- Audio and video are real time data, meaning
that they must be presented to the observer in strict time sequence --
neither too fast nor too slow. For historical reasons, computer
engineers developed much of their technology using architectures,
called asynchronous architectures, which make it difficult to ensure
such strict timing. This meant that it was difficult for companies
like ours to use "off the shelf" computer technology to develop our
products.
. Analog Release Formats -- In many ways release formats have been the
slowest areas to shift to digital. Even today almost all video
programs reaching consumers arrive via analog formats (VCR cassettes,
conventional broadcast television, and conventional cable television).
The Digital Audio Compact Disc, of course, now accounts for the
majority of pre-recorded music sold to consumers in industrialized
countries. But most broadcast radio, as well as the audio accompanying
broadcast video, theatrical feature films, and pre-recorded video, is
still delivered mostly using analog formats. Slow transition of
release formats to digital technology has tended to retard adoption of
digital technology by professionals for "upstream" processes such as
editing.
Our company was founded to pursue the opportunities presented by this
major transition, and to facilitate the transition by offering professionals
compelling alternatives to traditional analog production tools.
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Professional DVD Production: DVD Creator & DVD Fusion
DVD-Video
Our DVD Creator(TM) and DVD Fusion(TM) workstations support preparation of
DVD-Video discs.
DVD-Video is a relatively new optical disc format, introduced in 1996,
which offers high quality video, surround audio, and interactivity on a Compact
Disc-sized disc. The DVD-Video format offers content publishers a wide range of
features and options:
. Video can be presented in the MPEG-1 or MPEG-2 compressed digital
video format. A number of video streams may be presented in parallel
so that, responding to user commands, the player may seamlessly jump
from stream to stream.
. Audio can be presented both as compressed digital stereo and
"surround" formats, as well as uncompressed "PCM" digital audio. Up to
eight audio streams may be presented simultaneously (and may also be
selected for playback based on real-time user decisions) -- to support
different language dialog tracks, or to allow stereo and surround
versions of the same audio program.
. Chapter marks may be specified for random access into the video
program. Subpictures (images overlaid on background video or still
images) may be included and can be used in a number of ways, for
example, to create animated "buttons" to facilitate user interaction,
or to display language subtitles. Still pictures may be presented with
audio and with subpictures. Extensive navigation capabilities are
available to permit users to select from various program branches, to
return to previous branch points or menus, etc.
DVD Creator and DVD Fusion Workstations
We offer a range of professional DVD production workstations under the DVD
Creator and DVD Fusion trade names. Generally speaking DVD Creator workstations
offer more extensive capabilities to specialized professionals, at a somewhat
higher price points, while DVD Fusion workstations are designed for greater
ease of use and are targeted at less specialized video professionals at
somewhat lower price points. The two product lines share common technology and
can perform most of the same functions. We offer both lines in many
configurations so that customers can specify a workstation suited to their
particular needs and style of operation.
In the following discussion, unless the context indicates otherwise,
please understand that when we refer to "DVD Creator" we are referring to "DVD
Fusion" as well.
Platforms; Platform Risk
We introduced DVD Creator for the Macintosh in 1996. In 1999 we introduced
DVD Fusion for the Macintosh. In early 2001 we introduced DVD Fusion for the
Windows platform. We may, in the future, introduce versions of DVD Creator for
the Windows platform as well.
Because all of our DVD Creator workstations are currently Macintosh based,
and because many of our DVD Fusion systems will continue to be Macintosh based,
we are subject to certain risks. Among these are:
. We are dependent on Apple Computer continuing to ship and sell certain
models of the Macintosh, particularly models that can support use of
our plug-in PCI hardware (relevant to the higher priced models of DVD
Creator and DVD Fusion).
. Our Macintosh users generally demand that we maintain compatibility
with the latest models of the Macintosh and the Macintosh OS. In this
regard, in March of 2001 Apple Computer announced that Macintosh OS X
would now be available for use with its Macintosh computers. Recently,
Apple Computer has announced that new models of the Macintosh will be
delivering with OS X,
4
though those machines will still be able to run the earlier 9.x
versions of the Macintosh OS. Industry observers anticipate that at
some point before the end of 2001 or in early 2002, new Macintosh
computers will be able only to run with OS X. While OS X currently
offers a "compatibility mode" which supports OS 9.x compatible
applications, we believe that we will soon have to modify our
Macintosh Creator and Fusion applications to OS X for Creator and
Fusion to continue to be able to run with the latest Macintosh models.
Such a modification may be difficult to accomplish and if it proves to
be lengthy our revenues could be significantly reduced in the interim.
. Apple Computer has acquired DVD authoring technology and has
introduced products that compete with some of our products (please see
discussion under "Competition" at page 15, below).
DVD Creator Functions
DVD-Creator supports the three basic processes required to prepare audio
and video programming in the DVD-Video format. These are:
. MPEG-2 Video Encoding -- MPEG-2 and MPEG-1 video are the standards for
DVD-Video discs. MPEG is a digital video format that compresses the
original digital video stream to reduce bandwidth and storage
requirements by 90 to 95% but with little or no loss in perceived
quality.
. Audio Preparation and Encoding -- DVD-Video supports uncompressed
("PCM") digital audio as well as MPEG-2 and Dolby Digital compressed
formats.
. Format Authoring -- To support the advanced features of DVD-Video,
particularly menu-drive interactivity and multiple video and audio
streams, the audio, video, graphic and text elements included in the
disc must be organized, linked and then "woven" together.
DVD Creator -- Subsystems & Configurations
DVD Creator includes three principal subsystems capable together of
performing all the tasks necessary for producing a finished DVD-Video disc
image, which can then be replicated on manufactured DVD discs. These subsystems
are:
. Video Encoding -- The DVD-Video standard specifies MPEG-2 and MPEG-1
compressed digital video as the video formats to be used on DVD-Video
discs. While a number of choices within the standard are possible, the
typically preferred format is variable bit rate MPEG-2 operating at an
average bit rate of approximately four Megabits per second. DVD
Creator includes an encoding system designed to support user control
of the encoding process, and facilitate the operation of the encoding
system with standard professional video tape recorders and other
typical peripherals.
. Audio Encoding -- DVD Creator includes the ability to encode audio
into the formats supported by DVD-Video, including MPEG-2 and Dolby
Digital compressed audio. In some configurations of DVD Creator we
include a SonicStudio system.
. Format Authoring -- The authoring subsystem takes individual
compressed video, audio, graphics, still picture and subpicture
elements and combines and organizes them along with instructions
specifying interactivity (i.e., the response DVD players will make
based on user manipulation of front panel buttons or remote control
buttons). The output of the authoring step is an "asset list,"
containing each of the individual elements, and a "script" describing
how the assets are combined and accessed via user commands. Because of
the large number of potential elements in a DVD title and the high
level of interactivity possible, the authoring subsystem is a
complicated software package.
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In addition to these main subsystems, DVD Creator includes two other
subsystems:
. Emulation -- Because of the complexity of a DVD title, users of DVD
Creator require the ability to preview the results of their work
before the time consuming step of producing a final output disc. We
offer a subsystem that permits this previewing.
. Formatting and Writing -- DVD Creator includes a subsystem to take the
output of an authoring session and then to combine the navigation
instructions together with the audio, video, text and graphic elements
in the particular sequence required by the DVD-Video standard. This
process, sometimes referred to as "multiplexing," produces a finished
DVD-Video disc image that can then be recorded to a recordable DVD
disc, or to the particular tape format that can be read by the
mastering systems at the replication plant that actually "cut" the
disc master using high-powered lasers.
DVD Creator/Fusion is sold in many different configurations. Our list
prices range from entry level Fusion systems at $4,000 to $55,000 for a full
Creator configuration (again, our prices do not include host computers, disk
storage or other peripheral devices). Customers can purchase upgrade options
for any version to increase the functionality of their systems. Typically,
customers will spend (including our products, plus typical host computer,
storage and peripherals) around $50,000 for their DVD Creator system and
$20,000 for their DVD Fusion system. Please remember that revenue reported in
our financial statements is usually based on the price we receive from dealers
net of dealer commissions, and is thus lower on average than indicated by these
illustrative prices, which are based on end user list prices.
DVD-Audio
Version 1.0 of the DVD-Video specification was published in August of
1996, and players were introduced into various regions of the world during late
1996, 1997 and 1998. At about the same time the DVD-Video specification was
being finalized, the DVD Forum (the standards-setting industry association for
DVD) formed a working group to develop a DVD-Audio format, intended to be a
sister format to DVD-Video, but to emphasize more audio features.
The DVD-Audio working group spent more than three years developing the new
DVD-Audio specifications in close collaboration with the major record music
companies. The DVD Forum released Version 1.0 of the new DVD-Audio
specification in April 1999. The first commercially released players compatible
with the new format became available in late 1999. We announced support for
this new specification in the fall of 1998, and began delivery of the first
software packages supporting preliminary and limited DVD-Audio authoring early
in 1999 as part of our DVD Creator product line. We introduced new releases of
DVD-Audio support on a phased release basis during the balance of 1999 working
closely with player manufacturers and early DVD-Audio content publishers.
At this time the outlook for the DVD-Audio format is unclear. While some
amount of title production is underway, and while a limited number of DVD-Audio
compatible players are available in major market areas, the ultimate success of
the format will depend on acceptance by consumers of the format and we are
unlikely to know this for one to two more years.
The Daikin Products
On February 28, 2001 we announced an agreement with Daikin to acquire
their professional DVD authoring tool business. Under the terms of that
agreement we acquired a number of Daikin products including Scenarist and
ReelDVD, as well as the technology underlying those products. A number of
Daikin employees based in North America joined our company in early March.
Since the announcement, engineering for the Daikin products has been continued
by a team of Daikin engineers based in Osaka, Japan. We anticipate that support
for the Daikin products will be transferred to Sonic's development organization
in Novato by the end of the summer of 2001. We also anticipate that one or more
of the Daikin engineers will join our organization on a permanent basis. Since
the announcement of the agreement, a sales and marketing unit of Daikin,
located
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in Tokyo, Japan, has served as our exclusive distributor for the former Daikin
products in Japan. If you are interested in learning more about the other terms
of this transaction, please see our reports on Form 8K and Form 8K/A filed with
the Securities Exchange Commission, dated March 14 and May 14, 2001,
respectively.
Scenarist
Scenarist is a software product for DVD-Video authoring. Scenarist is
designed as a tool for "Hollywood" video professionals. Scenarist gives
authoring professionals a great degree of control over the interactivity and
feature set of DVD titles they produce. Scenarist also offers extensive
"scripting" capabilities that can be used by DVD-Video production facilities to
automate much of the work involved in producing multiple versions of the same
title. For example it can be used on a movie release on DVD-Video that will be
released in different parts of the world with different language audio and
subtitle tracks. It can also be used in producing various DVD-Video titles that
share a common "look and feel," for example, a set of class movie titles being
released as part of a series.
First released in 1996, Scenarist was the first commercially available
DVD-Video authoring tool. It enjoys significant acceptance among high end
authoring facilities. Because Scenarist's formatting engine has the longest and
broadest experience in the industry, the product is acknowledged by many
professionals as the DVD-Video production industry's "benchmark" for stable
production of standard DVD-Video titles.
Scenarist originally was released for use on computers manufactured by
Silicon Graphics running the Irix operating system. The current version of
Scenarist is intended for use on the Windows operating system.
In rough terms, Scenarist is targeted at the upper end of the market
targeted by DVD Creator. Since the introduction of the product in 1996,
approximately 950 copies of Scenarist have been sold.
We plan to continue to develop and enhance Scenarist as part of our
overall professional DVD strategy, and we plan to include the existing users of
Scenarist among our customers for future offerings.
ReelDVD
ReelDVD is a software product targeted at video professionals who are not
experts in the DVD-Video specification but who need significant flexibility in
utilizing the features of the DVD-Video specification. Roughly speaking,
ReelDVD targets the same video professional customer as DVDit!-PE or DVD
Fusion. ReelDVD is designed for use on the Microsoft Windows Operating System.
ReelDVD was introduced by Daikin in 2000. Since its introduction approximately
1,450 copies of ReelDVD have been shipped.
We plan to continue to develop and enhance ReelDVD and to integrate sales
and distribution for ReelDVD with our other professional DVD sales efforts.
Professional DVD Market and Strategy
The Market for Professional DVD Production
We divide the professional DVD production market into three segments:
. "Hollywood" Segment--This segment includes facilities that prepare
film and video material for mass publication on DVD-Video discs. It
includes:
-- film and television studios,
-- production companies and other content owners, and
-- top flight independent video post production facilities which
provide services to such content holders.
Customers in this segment tend to cluster in major film and video product
centers including Hollywood/Los Angeles, New York City, Chicago, London,
Paris, Tokyo, Taipei, etc. Customers in this
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segment demand the very highest quality in terms of processing output,
strict adherence to standards, and are very concerned with the overall
efficiency of production since projects are often produced on tight
schedules. We estimate that there are a few thousand facilities and
organizations in this segment worldwide.
. "Corporate" Segment -- Customers in this segment prepare DVD-Video
discs for publishing a variety of kinds of information for sales,
training, and other communications purposes. The segment includes:
-- "in-house" departments of corporate, industrial, non-profit or
educational organizations, and
-- independent facilities who specialize in assisting such
organizations in preparing such material.
Customers in this segment are typically somewhat more budget constrained
than customers in the "Hollywood" segment. In certain instances, however,
production values and budgets equal or even exceed those typically
encountered in the Hollywood segment. They tend to be geographically more
dispersed. While efficiency of production is a key requirement of such
customers, compatibility with other, existing recording and post-
production equipment is a major concern of customers in this segment. This
segment is only now beginning to adopt DVD, though given the spread of
DVD-ROM in the personal computer industry, many industry observers predict
rapid growth in the use of DVD in this segment. We estimate that there are
potentially more than 100,000 facilities and organizations in this segment
on a worldwide basis.
. "Multimedia" Segment -- This segment includes developers of multimedia
entertainment and educational titles intended for a mass audience. Many
of the organizations in this segment previously were involved in the
production of CD-ROM, CD-I and computer based interactive entertainment
or educational titles. Customers in this segment tend to use DVD in
conjunction with specialized computer software and accordingly their
needs are more varied than those in the other segments. While
relatively few organizations in this segment have moved to DVD,
industry observers report a high level of interest in the DVD format.
We estimate that there are approximately 15,000 organizations that
might ultimately become involved in DVD-based production in this
segment.
As of March 31, 2001 we have shipped more than 2,510 DVD Creator systems
(including DVD Fusion systems) to customers in various locations around the
world.
Competition
The DVD-Video format has generated significant interest among professional
system suppliers. A number of companies currently provide MPEG-2 video
encoding capabilities, audio encoding capabilities and authoring systems for
the professional user. We believe that more companies will participate in this
market in the future.
A number of companies compete with all or part of our DVD Creator
offering. Our competitors include:
Apple Computer Mitsubishi
C-Cube Microsystems Optibase
Digital Vision Philips
Dolby Laboratories Pinnacle
Intec Pioneer
Lucent Sony
Matsushita (Panasonic) Spruce Technologies
Toshiba
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A number of these companies have financial or organizational resources
significantly greater than ours and/or greater familiarity with certain
technologies involved in DVD premastering solutions.
Strategy
We expect that our professional DVD business will account for a
significant portion of our overall business in the future. Our DVD strategy
will continue to be based on the following elements:
. Focus on Professional Applications -- Our DVD product and service
offerings are focused on video and audio professionals whose primary
concern is producing the highest quality DVD discs, in complete
compliance with worldwide standards, with a high level of efficiency.
We will continue to evolve DVD-related premastering tools that are
fully compatible with "industry-standard" input formats and typical
professional video and audio equipment sets.
. High Performance Tools -- Our DVD tools will offer professional users
the highest levels of performance, both in terms of power and
sophistication of processing, and in terms of maximizing production
efficiency.
. Flexible Configurations -- Because we market to a wide range of
professional customers, we have engineered DVD Creator as a
"workgroup" solution incorporating modular audio, video and authoring
subsystems to make it easy for facilities to re-arrange DVD workflow
quickly, and to comply easily with changing demands of their
customers. We plan to continue to implement this philosophy in future
DVD product offerings.
. Range of Product Offerings -- DVD has a number of potential uses,
including applications in corporate and industrial settings, as well
as in delivery of mass entertainment such as feature films, videos,
and recorded music. We plan to evolve each element of our DVD
premastering tool set -- video, audio and authoring -- to specifically
address the specialized needs of such emerging segments.
SonicStudio
A SonicStudio digital audio workstation consists of:
. one or more of our audio signal processing cards installed on a
Macintosh personal computer;
. one or more outboard interface boxes (which contain various styles of
professional interface connections used to link the workstation to
other audio devices in the studio); and,
. extensive applications software.
Applications for SonicStudio
Our customers use their SonicStudio systems to manipulate audio, applying
a number of processes to digital sound to prepare it for final release. Some of
these processes are quite specialized and technical. To give you a sense of the
capabilities of our workstations, here are some of the tasks typically
performed using SonicStudio workstations:
. Editing -- SonicStudio permits very precise editing of sound -- the
process by which pieces of sound are combined to create a single
resulting sound so that the existence of the original individual
pieces is imperceptible to the listener.
. EQ -- SonicStudio can be used to equalize, or EQ, the sound, a process
by which certain frequencies are emphasized or de-emphasized. EQ is
similar in concept to manipulating the bass and treble controls on a
consumer audio system, but with much greater precision and
sophistication.
9
. Mixing -- SonicStudio can be used to mix or combine together two sound
recordings into one. Mixing is often used in professional audio work
because it is more convenient to record individual elements at
different times and under different conditions. The individual
elements or tracks are combined or mixed together to produce the
resulting sound used in release.
. Noise Reduction -- We offer NoNOISE(R) as an option to SonicStudio.
NoNOISE is a suite of software tools which permits users to remove
unwanted noise from recordings. NoNOISE has been used extensively by
audio professionals, particularly to re-issue older recordings on
Compact Disc, and to clean up noisy location sound tracks for film and
broadcast video work. In 1997, our company was honored with a
technical Emmy(R) award for NoNOISE.
Customer Segments for SonicStudio
There are three major segments of SonicStudio customers:
. Mastering -- customers in this segment use our products to prepare
music recordings for release to consumers, primarily on Digital Audio
Compact Discs.
. Broadcast -- customers in this segment use our products to prepare
audio for broadcast on radio.
. Sound-for-Picture -- customers in this segment use our products to
prepare audio tracks used with film or video programming.
SonicStudio Customers
We have supplied SonicStudio workstations to many professional audio
facilities around the world. As of March 31, 2001, more than 4,620 SonicStudio
systems had been shipped to customers since the product was first introduced in
1990.
SonicStudio Configurations
We offer SonicStudio in a variety of configurations, and with various
hardware and software options. A customer could purchase a SonicStudio HD (the
current version of SonicStudio) system configured for basic two channel CD
premastering for approximately $9,000. A customer would pay approximately
$22,000 for a fully-featured SonicStudio HD system configured for NoNOISE sound
restoration. Please remember that we do not include the cost of the personal
computer or peripheral devices in our pricing. Remember also that revenue as we
report it on our financial statements is usually based on the net price we
receive from dealers, and is thus lower on average per system than indicated by
these illustrative prices, which are based on end user list prices.
Competition
We encounter competition from a number of companies when selling
SonicStudio. We compete with companies offering traditional analog production
tools, digital audio recording tools, digital audio processing devices, and
digital audio workstations. The key elements of competition include: product
features, cost effectiveness, product quality, customer support, and marketing
and sales.
Many of our competitors have greater financial, technical and marketing
resources than we do. Traditional professional audio competitors, such as Japan
Victor Corporation (JVC), Otari Corp., Sony Corporation and Studer AG (a
division of Harmon Industries), sell analog as well as digital systems. A
number of competitors supply digital audio workstations including Digidesign (a
division of Avid Technology), Fairlight, Studio Audio and Design, Ltd. (Sadie),
WaveFrame, Dalet, DSP Media, Spectral Design, Augan and others. Our products
compete also with various kinds of single function digital audio processing
devices. For example, noise reduction modules from Cambridge Audio Research
compete with the NoNOISE option for SonicStudio.
10
Strategy
. Our strategy with SonicStudio is to continue to offer products that
enhance professional productivity while meeting the specific needs of
each segment of our target markets.
Consumer and Prosumer DVD Authoring Products
DVDit!
In April 1999 we introduced our DVDit! product line. DVDit! is a highly
simplified DVD-video authoring tool. We announced two versions of DVDit! -- a
Standard Edition ("SE") and a Limited Edition ("LE"). We began shipping DVDit!
LE in September and DVDit! SE in December, 1999. DVDit! LE carries a suggested
retail price of $199; DVDit! SE carries a suggested retail price of $499.
In April, 2000 we introduced a new addition to the DVDit! product line --
Sonic DVDit! Professional Edition ("PE"). DVDit! PE increases DVDit!'s reach
with professional functionality previously found only on authoring systems
costing significantly more. DVDit! PE carries a suggested retail price of $999.
Shipments of DVDit! PE began in June 2000.
DVDit! Customers
DVDit! is intended to address the needs of a broad range of customers who
wish to author DVD-Video discs. Among DVDit!'s end user customers are:
. Consumers -- Individuals who use DVDit! to make DVD-Video discs from
home videos and the like for their personal enjoyment. We believe that
this group of customers demands software that is easy to learn, and is
reasonably priced.
. "Prosumers" -- The term "prosumer" describes both video enthusiasts
who make a significant investment of time and money in producing and
preparing amateur videos, and professional and business people who use
video in their work, but for whom video production is not a primary
business activity. Compared to consumers, this customer group tends to
be less price sensitive, and more concerned about a rich feature set,
but is unlikely to have deep knowledge of DVD-Video.
. "Desktop Professionals" -- This group of customers resembles very
closely the professional customers we described in discussing DVD
Creator, except that they typically do not have frequent or constant
use for DVD-Video authoring tools.
Trends Favoring DVDit!
We introduced DVDit! to take advantage of the following trends:
. Proliferation of MPEG Video -- Due to certain introductions by chip
and software makers, relatively high quality MPEG encoding systems are
becoming widely available at prices ranging down to a few hundred
dollars at retail.
. Availability of Lower Cost DVD Recording -- Until recently, DVD
recorders were relatively highly priced. In early 2001, the first of a
new generation of recorders was introduced by Pioneer at "street"
prices under $1,000. We anticipate a number of other manufacturers
will introduce DVD recorders during the rest of 2001, and that prices
for the recorders will decline to $500 and below, eventually becoming
as cheap as current day CD+RW recorders (which currently are available
for under $200).
. Ubiquitous Digital Video -- Relatively high quality digital video
camera/recorders based on the DV format were introduced in the past
three years aimed at professionals as well as consumers. Prices for
consumer DV cameras began declining below $1,000 during 2000.
Virtually every
11
manufacturer of professional and prosumer video editing systems is
intending to release DV compatible systems in 2001 as well.
. Rapid Growth in DVD Playback Units -- By the end of 1998, over ten
million DVD-Video playback units (including both set-top players and
DVD-equipped multimedia PCs) had been installed worldwide, according
to industry sources. By the end of 1999, this installed base had grown
to over 40 million and by the end of 2000 the installed base grew to
over 80 million. By the end of 2001 it is forecast to grow to as many
as 150 million units.
Distribution for DVDit!
Because DVDit! is aimed at a broader market than our traditional
professional products, we are building a distribution capability for it. There
are three elements to this effort:
. We are entering into "bundling" arrangements with various other
companies in which copies of DVDit! are included or "bundled" with
shipments of those companies' products. These companies (we refer to
them as "OEM Partners") are motivated to include our software as a
value-added offering for their customers. We are motivated to enter
into bundling arrangements because they generate revenue for us as
well as create a large installed base of customers to whom we can sell
upgraded or enhanced versions of our products. To facilitate such
bundling arrangements we have designed different versions of DVDit!
offering different levels of functionality so that we can bundle the
less functional versions. Currently we are shipping three such
versions--DVDit! LE ("Limited Edition"); DVDit! SE ("Standard
Edition"); and DVDit! PE ("Professional Edition").
. We have initiated a web-based retail store for our DVDit! products.
Our web store is intended both to meet retail demand for our DVDit!
products as well as to service upgrade orders for our products, in
particular, the upgrade orders which derive from bundle shipments by
our OEM partners.
. We are adding dealers and distributors for DVDit!, some of whom
already carry some of our professional products, but many of which do
not, targeting dealers and distributors specializing in digital video
applications as well as those who participate in the broader personal
computer marketplace.
Building distribution for DVDit! will be a time-consuming and expensive
process. Since this is a new kind of product for us, there is significant risk
that our efforts, or at least some of them, will not be successful.
DVDit! OEM Partners
As mentioned above, we have implemented a bundling distribution strategy
for DVDit! Our current OEM partners include:
Aplix Matrox
Avid Technologies Media 100
Canopus NEC
Compaq Panasonic
Dazzle Pioneer
Intervideo Sigma Designs
IO-Data Sony
Margi
Competition
We have encountered some competition to DVDit! since its introduction. We
also believe that a number of companies have or will introduce products that
compete directly or in part with DVDit! in the future. Competitors who have
announced or are delivering products that compete with our products include
MGI,
12
Pinnacle, Roxio, Spruce Technologies and Ulead. In addition, other companies
with greater financial and technological resources may be interested in
entering the growing consumer business for DVD creation.
In April 2000, Apple Computer announced the acquisition of the DVD
authoring business of Astarte Gmbh. Prior to the acquisition, Astarte sold a
DVD authoring system that competed primarily with our DVD Fusion product. In
January 2001, Apple announced two new DVD authoring products, which we presume
are based on Astarte's technology. The first product, iDVD, is intended for
consumer users and we believe will compete with MyDVD and DVDit! The second
product, DVD Studio Pro, is intended for professional users, and we believe
will compete with DVDit! PE, DVD Fusion and ReelDVD. Apple also announced the
availability of aggressively priced DVD recorders with certain models of the
Macintosh personal computer. The impact of Apple's product introductions may be
to reduce demand for our products.
MyDVD
In late 2000 we announced MyDVD, a DVD-video authoring product targeted at
consumer applications and carrying a suggested retail price of $99. Shipments
of MyDVD started in November 2000. The initial version of the product resembled
DVDit! (but with a simplified feature set and user interface).
We plan to produce a new version of MyDVD in the summer of 2001 with a
significantly modified user interface and a feature set specifically designed
for consumer use. Our belief is that as DVD recorders become widely available
in late 2001 and 2002, consumers will begin to utilize DVD recording for a
number of purposes, such as recording favorite home videos, recording favorite
video broadcasts, creating highly convenient and portable copies of videos
downloaded from the internet, and for copying videos published on VHS cassette
or DVD./2/
We anticipate that MyDVD will become an increasing part of our business
during the latter half of calendar 2001 and throughout 2002. We also anticipate
that competition for MyDVD will be severe and that we will confront competitors
with expertise and resources significantly greater than ours.
Technology Licensing Products
In the past two years we have begun to market products that permits other
companies to build software products of their own. At the current time we have
two such software offerings: "AuthorScript" and "ATL" (ATL was acquired as part
of the Daikin acquisition). In the following discussion, "AuthorScript" should
be taken to include both products.
AuthorScript is designed to make available to software product developers
Sonic's "back-end" engines for producing DVD-Video discs (and related formats
such as Video CD and Super Video CD). In AuthorScript we include the same
processing software that underlies the authoring subsystems we provide in DVD
Creator, DVD Fusion, DVDit! and MyDVD. We package this software with an
Application Programmer's Interface ("API"), that is a top level mechanism
permitting other companies' software engineers easily to access our processing
technology.
We believe that AuthorScript will be both a revenue source and a point of
strategic leverage for our company. Once a software product is developed using
one back-end technology, it is quite difficult and possibly de-stabilizing to
switch to another offering. We've consciously packaged AuthorScript in a way
which is attractive to software developers, and we license it to other
companies on terms that we believe are very reasonable. We anticipate that this
will create a stable and growing base of AuthorScript licensees as DVD
recordable technology spreads.
- --------
/2/We do not advocate violation of copyright laws by our customers. None
of our products contain software designed to circumvent the operation of
encryption or other protection systems (for example the "CSS" encryption system
commonly used by DVD-Video publishers to prevent digital copying of their
published video content.
13
OEM Customers; Sales Concentration
We generally market our products to end users as Sonic Solutions products.
However, from time to time we have concluded various "OEM" agreements with
other companies (in addition to those listed above for DVDit!), in which those
companies included our products as part of their product offerings. At the
present time we have one significant OEM relationship with Discreet Logic, a
division of Autodesk, in which we provide audio subsystems for use with some of
their high end video effects and editing workstations. Sales to Discreet
amounted to 11% and 7% of our total revenues in the fiscal years ended March
31, 2000, and 2001, respectively. Although we consider our relations with
Discreet to be good, we anticipate that at some point in the next two fiscal
years, Discreet may implement changes to its product line replacing or
eliminating our subsystems.
During the fiscal years ended March 31, 2000 and 2001, sales to our
Japanese distributor, Sanshin Electronics Company, amounted to 10% and 12%,
respectively, of total revenues. Sanshin is a distributor of all of our
products.
Apart from sales to Discreet and Sanshin, no other single customer
accounted for more than 10% of our total revenue during each of the past three
fiscal years.
COMPANY OPERATIONS
Marketing, Sales and Distribution
Marketing and Product Management
Our marketing organization plans and manages development of our products
and manages promotion of them in the market. We currently have seven employees
in marketing, all based in our headquarters office in Novato, California,
including product marketing managers, and marketing communications and design
professionals.
Field Sales Force
We sell our professional workstation products through our field sales
force in combination with a network of professional audio/video dealers. We
currently employ 25 people in our field sales organization. Sales personnel are
based in our headquarters office in Novato, California as well as at our
offices in London (covering Europe) and in Tokyo (covering the Pacific Rim). We
have other sales personnel based out of home offices in Chicago, Los Angeles,
Florida, Milwaukee, Boston, Taipei and New York City. Our field sales force
includes sales managers and sales engineers. Most of our field sales personnel
operate under compensation arrangements in which a substantial portion of their
compensation is contingent upon performance relative to revenue targets.
Although all members of our sales organization are familiar with all of
our products, some of our sales personnel focus on DVD Creator, some on DVDit!,
and some on SonicStudio.
Dealers
The vast majority of our workstation sales involve one of our dealers.
Dealers play an important role in our sales and support efforts. They stimulate
demand in their regions, they prospect for and qualify potential new customers,
they give product demonstrations, they close sales, and they assist in post-
sale installation, training and support. Dealers very often sell peripheral
equipment along with our products so that customers can obtain a complete
workstation configuration from one source.
We have dealers in most areas of the world. We generally do not grant
contractual exclusivity to our dealers, though as a matter of practice,
depending on the dealer's territory and competence, we may maintain only one
dealer in a particular region.
14
Recruiting and maintaining dealers can be a difficult process. Because our
products are sophisticated, our dealers need to be technically proficient and
very familiar with professional audio and video production work. Dealer
organizations sometimes have limited financial resources, and may experience
business reversals for reasons unrelated to our product lines. The attractive
dealers in a region may be carrying competing products.
Our dealers are specialized to some extent by product line. Many
SonicStudio dealers do not carry DVD Creator products, and likewise many DVD
Creator dealers do not carry SonicStudio products. DVDit! dealers often do not
carry our professional product lines. Some dealers carry two or all three of
our product lines. The following table shows our current dealer count by
product line and region of the world:
------------ -------------- -------------- -------------- --------------
SonicStudio DVD Creator DVDit! Total
------------ -------------- -------------- -------------- --------------
Americas 19 37 14 42
Europe 40 37 16 44
Pacific Rim 17 24 9 33
------------ -------------- -------------- -------------- --------------
In the above chart, "Total" is less than the sum of columns because one dealer
organization sometimes carries more than one of our product lines.
Employees
At March 31, 2001, we employed 96 full-time-equivalent employees,
including the following:
#
Employees Function
--------- ------------
Marketing, Sales
and Customer
50 Support
Software and
Hardware
32 Engineering
5 Manufacturing
Administration
9 and Finance
To a very great degree our success in the future will depend on our
ability to recruit, retain and motivate engineering, technical, sales,
marketing and operations professionals. Recently the U.S. labor market has been
quite tight, and demand for technology professionals has been very strong. To
make matters worse, our company participates in what is perceived to be a "hot"
area of the "high tech" industry. We have found that recruiting high caliber
individuals is difficult and have had to expend considerable efforts in this
area.
No labor unions represent any of our employees. We have never experienced
a work stoppage, slowdown or strike. We believe that our employee relations are
good.
Customer Support
Customer support is important to professional users. This is why we offer
our customers the SonicCare(TM) maintenance program. Customers purchase annual
SonicCare service contracts from us that provide for:
. ongoing software upgrades,
. telephone support,
. "swap" replacement hardware in case of hardware failure, and
. preferential access to new products and new versions of software.
15
Customers typically add a SonicCare option to their initial system
purchase and a significant portion of customers renew SonicCare yearly.
To administer SonicCare, we employ a staff of product support specialists
at our Novato headquarters and in our field offices. We provide unlimited
telephone support during scheduled support hours to all customers under
SonicCare. Customer support calls also provide us with an important means of
understanding customer requirements for future product enhancements. We also
undertake customer calling programs in which customers are contacted by a
customer support representative to assess their level of satisfaction and to
acquaint them with new product offerings.
Research and Development
Our research and development staff includes a total of 32 hardware and
software engineers and technicians and technical specialists. We tend to hire
research and development personnel with backgrounds in digital audio signal
processing, digital video image processing, distributed networking and computer
systems design. Since the Daikin acquisition, engineering for the Daikin
products has been continued by a team of Daikin engineers based in Osaka,
Japan. We anticipate that support for the Daikin products will be transferred
to Sonic's development organization in Novato by the end of the summer of 2001.
We also anticipate that one or more of the Daikin engineers will join our
organization on a permanent basis. Our development team exhibits a number of
technology capabilities including the following that we believe are
particularly important in light of our strategy and market position:
. Digital Signal Processing -- This is the term used to describe the
sophisticated mathematical processing by which aural and visual
signals are processed in computer-based settings. Our engineering team
includes individuals experienced at providing sophisticated digital
signal processing solutions to meet the quality and performance
requirements of audio and video professionals.
. Real Time Architectures -- Our engineers are experienced in dealing
with the requirements of high bandwidth, real time data in computer-
based settings. We believe that has helped us to develop products that
provide cost effective solutions for professional applications.
. Craft Familiarity -- Our engineers are experienced in the needs and
work patterns of audio, film and video professionals. This helps us
develop products which can be adopted more quickly by creative audio
and video professionals.
Backlog
We schedule our production of products based on our projections of
customer demand, and we generally ship products within a few days of acceptance
of a customer purchase order so at any given time we have little or no order
backlog. With few exceptions, customers may cancel or delay orders with little
or no penalty. Thus, even to the extent that we have backlog, we do not think
that it is a reliable indicator of future revenue levels.
Manufacturing and Suppliers
How We Manufacture
We have typically contracted with various electronics manufacturing and
assembly houses to manufacture the hardware components of our products. Most of
these contractors are located in the San Francisco Bay Area. Our staff performs
some assembly, integration and testing at our Novato, California headquarters.
16
Sole-Sourced Components
We utilize a number of components in our products that are available from
only a single source. We purchase these sole-source components from time to
time, that is, we do not carry significant inventories of these components and
we have no guaranteed supply agreements for them. We have experienced shortages
of some sole-sourced components in the past. We are likely to experience
similar shortages at some point in the future. Such shortages can have a
significant negative impact on our business.
Outsourcing
Over the past three years, we have shifted our hardware manufacturing to
an "outsourcing" approach. Under outsourcing we contract with a single partner
organization which takes responsibility for procuring parts, and for
manufacturing them into complete, tested assemblies which are then released to
us according to our instructions. Our current outsourcing arrangement is with
Arrow Electronics, Inc. We believe that outsourcing provides us with increased
flexibility to increase or decrease production, and allows us to operate our
business with substantially reduced inventories thereby reducing financing
requirements. During the 2001 fiscal year, we produced approximately 90% of our
hardware via outsourcing. We plan to continue this outsourcing approach.
While we believe that outsourcing is advantageous for Sonic, it makes us
very dependent on a single production source. Financial, operational, or supply
problems encountered by our outsourcing partner or its sub-contractors could
seriously hamper or interrupt our ability to manufacture, sell and ship our
products.
Proprietary Rights
General Approach
We rely on a combination of the following to protect our proprietary
rights in our products:
. patents,
. trade secrets,
. copyright law,
. trademark law,
. contracts, and
. technical measures
We generally sell our products subject to standard purchase and license
agreements that restrict unauthorized disclosure of our proprietary software
and designs, or copying for purposes other than the use intended when the
product is sold.
Patents
We have applied in the United States for patents covering certain of our
technologies and will probably apply for more in the future. We will probably
also apply for foreign patents. We have been granted U.S. Patent No. 5,812,790:
"Variable encoding rate plan generation" covering certain aspects of MPEG-2
Video encoding technology; and U.S. Patent No. 6,047,356: "Method of
dynamically allocating network node memory's partitions for caching distributed
files" covering a distributed file system, and may be granted additional
patents in the future. Of course, we can't be sure that our current or future
patent applications will be granted. Nor can we be certain that we can
successfully prosecute claims against others based on our patents, or defend
our patents against the claims of others. We believe that becoming involved in
patent litigation can be quite expensive and is highly uncertain in terms of
outcome.
The status of patent protection in our industry is not well defined
particularly as it relates to software and signal processing algorithms. In the
past several years there seems to have been a trend on the part of
17
patent authorities to grant patents in audio and video processing techniques
with increasing liberality. We believe that it is quite possible that some of
our present or future products may infringe issued or yet to be issued patents.
It is almost certain that we will be asked by patent holders to respond to
infringement claims. If such patents were held to be valid, and if they covered
a portion of our technology for which there was no ready substitute, we might
suffer significant market and financial losses.
Our products involve the use of certain technologies in which the overall
patent situation is acknowledged by most industry observers to be very unclear.
For example, patent coverage and license availability for MPEG-2 video encoding
and decoding is currently quite uncertain. While one group of companies has
attempted to create a single licensing entity for this technology (called
"MPEG/LA"), not all relevant patent holding companies have joined this entity.
We plan to continue to monitor this area and to act prudently to avoid needless
litigation and entanglements while continuing to offer our products.
Trade Secrets
We rely to a great extent on the protection the law gives to trade secrets
to protect our proprietary technology. Our policy is to request confidentiality
agreements from all of our employees and key consultants, and we regularly
enter into confidentiality agreements with other companies with whom we discuss
any of our proprietary technology.
Despite trade secret protection, we cannot be sure that third parties will
not independently develop the same or similar technologies. Despite contract
and procedural measures, we believe that it is practically impossible to guard
against unauthorized disclosure or misuse of technology to which we have
granted third parties access. We also have significant international
operations. Many foreign countries, in law or in practice, do not extend the
same level of protection to trade secrets as does U.S. law.
Current Infringement Issues
In the past we have been advised of various infringements of patents and
trademarks. We do not believe that in any such situation currently known to us
we are at risk of material loss or serious interruption of our business. We may
be incorrect in this assessment, of course.
Geographic Exposure
We have for many years realized a significant proportion of our revenues
from sales outside the United States. In some fiscal quarters non-U.S. revenue
has constituted as much as 52% of our revenues. In the fiscal year ended March
31, 2001, 47% of our revenues came from sales outside the United States. We
believe that it is quite likely that at some points in the future an even
higher percentage of our sales will be generated outside the United States.
Because of our foreign sales, we are exposed to a number of factors that
would not be relevant if our sales were largely made within the United States.
Currency movements which make the U.S. dollar stronger relative to foreign
currencies can effectively raise the price of our products to foreign
customers, reducing demand for our products. Import restrictions, tariffs, and
foreign product regulations (particularly those dealing with product safety and
RF emissions) may also impede our ability to do business in foreign countries.
Item 2. PROPERTIES
Our principal administrative, sales and marketing, research and
development and support facility is located at 101 Rowland Way in Novato,
California and consists of approximately 30,000 square feet under a lease which
expires in 2006.
We also have sales offices located in London and Tokyo.
Item 3. LEGAL PROCEEDINGS
We are not a party to any legal proceedings.
18
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the fiscal year ended March 31, 2001, we did
not submit any matters to a vote of our security holders.
19
PART II
Item 5. MARKET FOR SONIC SOLUTIONS' COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Our common stock is listed on the Nasdaq National Market. As of March 31,
2001 there were approximately 175 registered holders of our common stock. We
believe, however, that many beneficial holders of our common stock have
registered their shares in nominee or street name, and that there are
substantially more than 175 beneficial owners. The low price and high price of
our common stock during the last eight quarters are as follows:
-----------------------------------------------------------------------------
Low Price High Price
--------- ----------
-----------------------------------------------------------------------------
Quarter ended June 30, 1999............................ $3.875 $ 7.125
Quarter ended September 30, 1999....................... $2.000 $ 5.000
Quarter ended December 31, 1999........................ $1.688 $ 5.313
Quarter ended March 31, 2000........................... $3.875 $12.500
Quarter ended June 30, 2000............................ $3.250 $ 9.250
Quarter ended September 30, 2000....................... $1.688 $ 4.469
Quarter ended December 31, 2000........................ $1.000 $ 3.063
Quarter ended March 31, 2001........................... $1.031 $ 2.625
-----------------------------------------------------------------------------
We have not paid any dividends on our Common Stock during the periods set
forth above. It is presently the policy of the Board of Directors to retain
earnings for use in expanding and developing our business. Accordingly, we do
not anticipate paying any cash dividends on the Common Stock in the foreseeable
future.
In February 2001, we issued 700,000 shares of Series D Convertible
Preferred Stock to Daikin Industries in conjunction with the acquisition of the
DVD business and assets of Daikin. Each share of Series D Convertible Preferred
Stock is convertible into one share of Common Stock. These securities were
exempt from registration pursuant to Section 4(2) of the Securities Act of
1933. These securities were sold to one investor which represented it was
sophisticated and accredited.
20
Item 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with
the financial statements and related notes thereto and "Management's Discussion
and Analysis of Financial Condition and Results of Operations" appearing
elsewhere in this Form 10-K. The selected financial data presented below under
the caption "Statement of Operations Data" and "Balance Sheet Data" for, and as
of the end of, each of the years in the five-year period ended March 31, 2001
are derived from the financial statements of Sonic Solutions, which financial
statements have been audited by KPMG LLP, independent certified public
accountants. The financial statements as of March 31, 2001 and 2000, and for
each of the years in the three-year period ended March 31, 2001, and the report
thereon, are included elsewhere in this Form 10-K.
Years Ended March 31,
--------------------------------------
1997 1998 1999 2000 2001
------ ------ ------ ------ ------
(in thousands except share
amounts)
STATEMENT OF OPERATIONS DATA:
Net revenue........................... 15,911 19,881 21,899 20,827 16,519
Cost of revenue....................... 7,432 10,209 9,547 8,992 5,892
------ ------ ------ ------ ------
Gross profit.......................... 8,479 9,672 12,352 11,835 10,627
Operating expenses:
Marketing and sales................... 6,000 7,257 7,216 8,938 8,710
Research and development.............. 5,737 6,037 5,137 6,155 5,148
General and administrative............ 1,837 1,603 1,556 2,284 2,514
------ ------ ------ ------ ------
Total operating expenses.............. 13,574 14,897 13,909 17,377 16,372
------ ------ ------ ------ ------
Operating loss........................ (5,095) (5,225) (1,557) (5,542) (5,745)
Other income (expense)................ (96) (651) (302) (249) (110)
Provision (benefit) for income taxes.. -- -- -- (97) 0
------ ------ ------ ------ ------
Net loss.............................. (5,191) (5,876) (1,859) (5,694) (5,855)
====== ====== ====== ====== ======
Basic loss per share.................. (0.69) (0.76) (0.21) (0.56) (0.47)
Weighted average shares used in
computing per share amounts.......... 7,542 7,761 8,896 10,460 12,402
Diluted loss per share................ (0.69) (0.76) (0.21) (0.56) (0.47)
Weighted average shares used in
computing per share amounts.......... 7,542 7,761 8,896 10,460 12,402
BALANCE SHEET DATA:
Working capital....................... 6,263 1,164 1,167 4,976 458
Total assets.......................... 15,889 12,630 13,765 14,968 11,738
Shareholders' equity.................. 8,430 5,418 5,932 8,750 5,455
21
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW; CERTAIN FACTORS THAT MAKE FUTURE RESULTS DIFFICULT TO PREDICT;
CERTAIN ITEMS TO REMEMBER WHEN READING OUR FINANCIAL STATEMENTS
Our quarterly operating results vary significantly depending on the timing
of new product introductions and enhancements by ourselves and by our
competitors. Our results also depend on the volume and timing of orders which
are difficult to forecast. Because our customers generally order on an as-
needed basis, and we normally ship products within one week after receipt of an
order, we don't have an order backlog which can assist us in forecasting
results. For all these reasons, our results of operations for any quarter are a
poor indicator of the results to be expected in any future quarter.
A large portion of our quarterly revenue is usually generated in the last
few weeks of the quarter. Since our ongoing operating expenses are relatively
fixed, and we plan our expenditures based primarily on sales forecasts, if
revenue generated in the last few weeks of a quarter do not meet our forecast,
operating results can be very negatively affected.
We capitalize a portion of our software development costs in accordance
with Statement of Financial Accounting Standard No. 86. Such capitalized costs
are amortized to cost of revenue over the estimated economic life of the
product, which is generally three years. See Note 4 of Notes to Financial
Statements.
RESULTS OF OPERATIONS
The following table sets forth certain items from Sonic Solutions'
statements of operations as a percentage of net revenue for fiscal years 1999
through 2001:
Years ended
March 31,
---------------------
1999 2000 2001
----- ----- -----
Net revenue 100.0% 100.0% 100.0%
Cost of revenue 43.6 43.2 35.7
----- ----- -----
Gross profit 56.4 56.8 64.3
Operating expenses:
Marketing and sales 33.0 42.8 52.7
Research and development 23.5 29.6 31.2
General and administrative 7.0 11.0 15.2
----- ----- -----
Total operating expenses 63.5 83.4 99.1
----- ----- -----
Operating loss (7.1) (26.6) (34.8)
Other expense (1.4) (1.2) (0.7)
Provision (benefit) for income taxes -- (0.5) --
----- ----- -----
Net loss (8.5)% (27.3)% (35.5)%
===== ===== =====
COMPARISON OF FISCAL YEARS ENDED MARCH 31, 2001, 2000 and 1999
Net Revenue. Our net revenue decreased from $21,899,000 in fiscal 1999 to
$20,827,000 in fiscal 2000 to $16,519,000 in fiscal 2001, representing a
decrease of 5% from fiscal 1999 to fiscal 2000 and a decrease of 21% from
fiscal 2000 to fiscal 2001. The decreases in fiscal 2000 and fiscal 2001 were
primarily due to decreases in sales of our professional audio and DVD systems
which were partially offset by increases in sales of our consumer DVD products,
including DVDit!. The decreases were also partially offset by sales of Daikin
related products. See earlier discussion regarding the acquisition of The DVD
Software Development Business of Daikin Industries, Ltd.
22
International sales accounted for 47%, of our net revenue in each of the
fiscal years 1999, 2000, and 2001. See Note 10 of Notes to Financial
Statements. International sales have historically represented around 50% of our
total sales, and we expect that they will continue to represent a significant
percentage of future revenue.
Cost of Revenue. Our cost of revenue decreased from 43.6% of net revenue
in fiscal 1999 to 43.2% in fiscal 2000 to 35.7% in fiscal 2001. The decreases
in cost of revenue in fiscal year 2000 and fiscal year 2001 were primarily due
to a shift in sales product mix towards higher margin consumer DVD systems and
to the reduction of hardware as a percentage of revenue in our professional DVD
systems.
Marketing and Sales. Our marketing and sales expenses increased from
$7,216,000 in fiscal 1999 to $8,938,000 in fiscal 2000 and decreased to
$8,710,000 in fiscal 2001. Marketing and sales represented 33.0%, 42.8% and
52.7% of net revenue for fiscal 1999, 2000 and 2001, respectively. Our
marketing and sales expenses increased in fiscal 2000 primarily due to
increases in salary expenses as a result of an increase in headcount, and
increases in advertising and marketing costs related to our DVD product lines.
Our marketing and sales expenses decreased in fiscal 2001 primarily due to
lower commission expenses. Our marketing and sales headcount increased from
thirty-seven at March 31, 1999 to forty at March 31, 2000 to forty-nine at
March 31, 2001. Dealer and employee commission expenses, as a percentage of net
revenue decreased from 4.7% in fiscal 1999 and fiscal 2000 to 4.4% and fiscal
2001.
Research and Development. Our research and development expenses increased
from $5,137,000 in fiscal 1999 to $6,155,000 in fiscal 2000 and decreased to
$5,148,000 in fiscal 2001. Our research and development expenses as a
percentage of net revenue were 23.5% in fiscal 1999, 29.6% in fiscal 2000, and
31.2% in fiscal 2001. We capitalize a portion of our software development costs
in accordance with statement of Financial Accounting Standard No. 86. (This
means that a portion of the costs we incur for software development are not
recorded as an expense in the period in which they are actually incurred.
Instead they are recorded as an asset on our balance sheet. The amount recorded
on our balance sheet is then amortized over the estimated life of the products
in which the software is included.) Our research and development expenses
increased in fiscal 2000 primarily due to increased headcount from thirty at
March 31, 1999 to thirty-two at March 31, 2000 and due to consulting expenses
associated with introductions of new products, including our DVDit! product.
Research and development expenses decreased in fiscal 2001 due to reduced
consulting expenses associated with new product development. Headcount remained
consistent at thirty-two from March 31, 2000 to March 31, 2001. Consulting
expenses can fluctuate significantly from period to period depending upon the
status of software development projects and our schedule of new product
introductions.
General and Administrative. Our general and administrative expenses
increased from $1,556,000 in fiscal 1999 to $2,284,000 in fiscal 2000 to
$2,514,000 in fiscal 2001. These expenses represented 7.0% of net revenue in
fiscal 1999, 11.0% of net revenue in fiscal 2000 and 15.2% of net revenue in
fiscal 2001. Our general and administrative expenses increased in fiscal 2000
primarily due to a charge to bad debt expense of $600,000 which represented an
additional reserve for sales to audio professionals and distributors who are
experiencing liquidity difficulties due to a decline in their business. General
and administrative expenses increased in fiscal 2001 primarily due to an
increase in legal and professional expenses.
Other Income and Expense. Other expense on our statement of operations
includes primarily the net amount of interest or other financing charges we
have incurred due to borrowings. For our 1999, 2000 and 2001 fiscal years, we
incurred interest and other financing charges related to financing agreements
we had with entities associated with Hambrecht & Quist, as well as borrowings
under our bank credit line. Other income includes the interest we earned on
cash balances and short term investments.
Provision for Income Taxes. In accordance with Statement of Financial
Accounting Standards No. 109, we made no provision for income taxes for our
1999 and 2001 years. For the 2000 fiscal year a benefit was recorded (during
the quarter ended June 30, 1999) to reflect the refund due us following the
conclusion of an Internal Revenue Service audit. During the 2001 fiscal year we
exhausted our ability to carryback tax losses resulting from operations in the
fiscal year ended March 31, 1997.
23
Liquidity and Capital Resources. In December 1996, we entered into a Loan
and Security Agreement (the "Loan Agreement") with Silicon Valley Bank. The
Loan Agreement, which we sometimes refer to as our "bank credit line," has been
modified or renewed at various times since December 1996. Our bank credit line
expired on March 17, 2001.
In March, 1998, we renegotiated a previous financing arrangement with
Hambrecht & Quist Guaranty Finance. The agreement we reached involved the
restructuring of $3,000,000 debt into $1,500,000 of Series C Convertible
Preferred Stock (see note 7 of Notes to Financial Statements) and $1,500,000 of
debt. The interest rate on such restructured debt was 7.25% and was due in
October 1999. We filed a Form S-3 Registration Statement under the Securities
Act of 1933 to register the resale of the 461,538 shares of the Company's
Common Stock which underlie the Series C Convertible Preferred Stock issued to
Hambrecht & Quist Guaranty Finance. In connection with the agreement, the
exercise price of 90,000 of the $10.00 warrants issued with the original
arrangement reached in December 1996 was lowered to the fair value of common
stock of $3.25. We accounted for this transaction by revaluing the new
warrants, using comparable assumptions as the original warrant grant, and the
resultant value of $90,000 was amortized over the new loan period. In June,
1998, 90,000 of the $3.25 warrants were exercised on a "net exercise" basis,
and the warrant holder received 29,691 shares of common stock. During the
fiscal years ended March 31, 1999 and March 31, 2000, 167,500 and 292,000
shares of the Preferred Stock were converted into common stock pursuant to this
financing arrangement.
In October, 1999, we renegotiated a financing arrangement with Hambrecht &
Quist Guaranty Finance. The agreement we reached involved the restructuring of
$1,500,000 debt into 153,846 shares of Series C Convertible Preferred Stock and
$1,000,000 of debt. The interest rate on the restructured debt is 7.25% and the
debt and interest were payable in monthly installments through April 30, 2001.
In connection with this agreement, we issued warrants to purchase 120,000
common shares at an exercise price of $2.50. These warrants expire on April 30,
2006. We also enhanced the conversion rate of Hambrecht and Quist's existing
Series C convertible preferred stock so that each share of Series C convertible
preferred stock is convertible into 1.625 shares of common stock. The
beneficial conversion feature, warrants and new debt were recorded at their
relative fair values. We recorded $345,000 of deferred financing costs
attributable to this finance restructuring with Hambrecht & Quist Guaranty.
This amount is being amortized using the effective interest rate method to
interest expense over the term of the financing facility (18 months). The fair
value of the warrants was estimated using the Black-Scholes option pricing
model and the following assumptions: volatility of .50, risk free interest rate
of 6% and expected life equal to the contractual terms. We filed a Form S-3
Registration Statement under the Securities Act of 1933 to register the shares
of the common stock which underlie the Series C convertible preferred stock and
the 120,000 shares of our common stock which underlie the warrants issued to
Hambrecht & Quist Guaranty Finance.
In December, 1997, we secured a $7,000,000 equity-based line of credit.
Under this arrangement, we had the right to draw up to a total of $7,000,000 in
cash in exchange for common stock. Pricing of the common stock issued was based
on the market price of our common stock at the time of a draw subject to a 14%
discount and a 4% commission payable in common stock. The availability of the
credit line, and the amounts and timing of draws under the line were subject to
a number of conditions. In January, 1998, we filed a Form S-3 Registration
Statement under the Securities Act of 1933 to register the resale of shares
issued under this credit line. During the fiscal year ended March 31, 1998, we
drew $1,450,000 from this credit line for which we issued 618,130 shares of
common stock. During the fiscal year ended March 31, 1999, we drew an
additional $2,358,000 from this credit line for which we issued 903,870 shares
of common stock. This facility is no longer available to us.
On May 20, 1999, we secured a new equity-based line of credit by entering
into a new stock purchase agreement with Kingsbridge. Under this arrangement,
we were able to draw up to $12,000,000 in cash in exchange for common stock.
Pricing of the common stock issued under this arrangement was based on the
market price of our common stock at the time of a draw, discounted by 10% or
12%, depending upon the price
24
of our common stock. The availability of the credit line, and the amounts and
timing of draws under the line were subject to a number of conditions. On May
27, 1999, we filed a Registration Statement on Form S-1 to register for resale
the shares we may issue to Kingsbridge under this credit line and on August 12,
1999 the Statement became effective. During the fiscal year ended March 31,
2000, we drew $7,408,000 from the credit line for which we issued 1,800,000
shares of common stock. Because of limitations on the total number of shares
that could be issued under this line of credit, this facility is no longer
available to us and was terminated on March 14, 2000.
On May 4, 2000, we secured a new equity-based line of credit by entering
into a new stock purchase agreement with Kingsbridge. Under the new agreement,
we may draw up to $20,000,000 in cash in exchange for common stock. Pricing of
the common stock issued under this agreement is based on the market price of
our common stock at the time of a draw subject to discounts ranging from 8% to
12%. The availability of the credit line, and the amounts and timing of draws
under the lines are subject to a number of conditions, including a listing on
NASDAQ. On July 19, 2000, we filed a Registration Statement on Form S-1 to
register for resale the shares we may issue to Kingsbridge under this credit
line and on November 13, 2000 the Statement became effective. During the fiscal
year ended March 31, 2001, we drew $200,000 from the credit line for which we
issued 211,416 shares of common stock.
Our operating activities have used cash of $124,000 in fiscal year 1999,
$2,628,000 in fiscal year 2000 and $848,000 in fiscal year 2001. During those
fiscal years cash required by operating activities was not as great as our
operating losses due to the changes in operating assets and liabilities. In
addition to our operations, we utilized cash during the 1999, 2000, and 2001
fiscal years primarily to purchase new fixed assets, pay down debt obligations
and to develop and purchase software that was added to capitalized software.
During the 1999, 2000 and 2001 fiscal years we augmented cash on hand
primarily by drawing on the equity credit lines described above.
We believe that existing cash, cash equivalents and short term
investments, available credit and cash generated from operations, plus cash
available through the new equity based line of credit with Kingsbridge will be
sufficient to meet our cash requirements at least through the end of fiscal
year 2002.
As of March 31, 2001, we had cash and cash equivalents of $1,616,000 and
working capital of $458,000.
Risk Factors. You should carefully consider the risk factors set forth
below:
We have had losses in each of the past five years.
--------------------------------------------------
We were unprofitable during each of the last five fiscal years. For
example, in fiscal year 2001, we had a net loss of $5,855,000 and in fiscal
year 2000 we had a net loss of $5,791,000. We were unprofitable during the
first three quarters of the 1999 fiscal year and during each quarter of the
2000 and 2001 fiscal years. We may not be profitable at any time in the future.
Our lack of profitability could cause our share price to decline. The other
risks identified below could also cause the value of our shares to decline. We
cannot, however, estimate the likelihood that our shares will decline in value
or the amount by which they may decline.
During the last three years we had negative operating cash flows and
--------------------------------------------------------------------
expect this to continue.
- ------------------------
We might need additional financing in order to continue to operate. During
the last three fiscal years we had a negative operating cash flow of $124,000,
$2,628,000 and $848,000 for the fiscal years ended March 31, 1999, 2000 and
2001, respectively. This means that without access to outside capital we would
have had to cease or significantly curtail operations. We believe that we may
continue to run a negative operating cash flow for the foreseeable future, and
might continue to need to obtain additional financing to continue to operate.
If we are unable to obtain such financing, then we may have to cease or
significantly curtail operations.
25
Our stock purchase agreement with Kingsbridge Capital Limited may be
--------------------------------------------------------------------
unavailable or insufficient to meet our future cash needs.
- ----------------------------------------------------------
In May 2000, we entered into an agreement with Kingsbridge Capital Limited
which allows us to sell from time to time up to $20,000,000 of common stock to
Kingsbridge. In no event, however, can we sell any shares in an amount in
excess of 19.9% of our outstanding common stock. As of May 31, 2001, we had
sold under this agreement approximately 643,608 shares of common stock with
gross proceeds to us of approximately $650,000. Assuming our stock price
remains at $1.50 per share, the maximum number of shares we could sell in the
future to Kingsbridge under this agreement would be approximately 2,688,000
shares with gross proceeds of approximately $4,032,000.
Our ability to sell stock to Kingsbridge, however, is subject to a number
of terms and conditions, including, for example, continued listing of our stock
on NASDAQ, continued effectiveness of a registration statement, continued
accuracy of representations and warranties made to Kingsbridge and lack of
material adverse changes to our business. The risk to us is that, because of
these and other conditions, at the time we need cash in the future, the stock
sale arrangement with Kingsbridge may be unavailable or insufficient to meet
our cash needs. If the stock purchase agreement with Kingsbridge is unavailable
or insufficient to meet our needs when we need working capital, we may have to
cease or significantly curtail operations.
Any failure to successfully integrate the Daikin business we acquired on
------------------------------------------------------------------------
February 27, 2001 could negatively impact us.
- ---------------------------------------------
In February 2001, we acquired the DVD business and assets of Daikin. This
acquisition involves risks that could materially and adversely affect our
business and operating results. These risks include, among others:
. Distracting management from day-to day operations of our business;
. Costs, delays and inefficiencies associated with integrating acquired
operations, products and personnel;
. Incurring amortization expenses related to goodwill and other
intangible assets;
. The potential dilution resulting from conversion of the Preferred
Stock issued to Daikin;
. Undiscovered and unknown problems, defects or other issues related to
the Daikin products that become known to us only some time after
consummation of the acquisition;
. Negative reactions from our current resellers, or our current
customers, to the acquisition; and
. Negative reactions from the current resellers or the current customers
of the Daikin business to the acquisition of that business by us.
If new digital formats are unsuccessful, it is unlikely that we will
--------------------------------------------------------------------
generate sufficient revenues to recover our development cost.
- -------------------------------------------------------------
Our business involves new digital audio and video formats, such as DVD-
Video and DVD-Audio, and, more recently, the new recordable DVD formats
including DVD-RAM, DVD-R/RW and DVD+RW. If these formats prove to be
unsuccessful or are not accepted for any reason, there will be only limited
demand for our products.
We may have to incur significant product redesign costs if chip
---------------------------------------------------------------
manufacturers discontinue or redesign their products.
- -----------------------------------------------------
Our products are based on integrated circuits or "chips" produced by other
companies. If these chip manufacturers discontinue or redesign the chips we use
for our products, then we will likely incur significant costs to redesign our
products to handle these changes. We cannot estimate the amount of these costs
or the likelihood that we will have to redesign our products.
Our reliance on outsourcing and single suppliers for our manufacturing and
--------------------------------------------------------------------------
components makes us vulnerable to supplier operational problems.
- ----------------------------------------------------------------
Our outsourcing manufacturing program commits responsibility for almost
all of our manufacturing activities to a single supplier. In addition, we often
use components that are only available from a single source.
26
Reliance on a single supplier for manufacturing or for certain manufacturing
components makes us vulnerable to operating or financial problems encountered
by those suppliers.
If we fail to protect our products' intellectual property rights, such as
-------------------------------------------------------------------------
trade secrets, we may not be able to market our products successfully.
- ----------------------------------------------------------------------
Our products are based in large part on proprietary technology. To the
extent that we use patents to protect our proprietary rights, we may not be
able to obtain needed patents or, if granted, the patents may be held invalid
or otherwise indefensible. In addition, we make extensive use of trade secrets
that we may not be able to protect. To the extent we are unable to protect our
proprietary rights, competitors may enter the market offering products
identical to ours, with a negative impact on sales of our products.
Other companies' intellectual property rights may prevent our current or
------------------------------------------------------------------------
future product development and sales.
- -------------------------------------
We have never conducted a comprehensive patent search relating to the
technology we use in our products. There may be issued or pending patents owned
by third parties that relate to our products. If so, we could incur substantial
costs defending against patent infringement claims or we could even be blocked
from selling our products.
Other companies may succeed in obtaining valid patents covering one or
more of the key techniques we utilize in our products. If so, we may be forced
to obtain required licenses or implement alternative non-infringing approaches.
Our products are designed to adhere to industry standards, such as DVD-
ROM, DVD-Video, DVD-Audio and MPEG video. A number of companies and
organizations hold various patents that claim to cover various aspects of DVD
and MPEG technology. We have entered into license agreements with certain
companies relative to some of these technologies. For instance, we have entered
into license agreements with Dolby Licensing Corporation covering Dolby Digital
Audio and with Meridian Audio Limited covering Meridian Lossless Packing. Such
license agreements may not be sufficient to grant all of the intellectual
property rights to us necessary to market our products.
Regarding claims for patent infringement, some of the purchase and license
agreements we have with our customers allocate responsibility to our customers
for satisfying any such claims, while some of our customer purchase and license
agreements allocate such responsibility to us. Regardless of the provisions of
our customer purchase and license agreements, third parties could pursue us
claiming that our products infringe various patents. Patent infringement
litigation could be time consuming and costly. If the litigation resulted in an
unfavorable outcome for us, we could be subject to substantial damage claims
and a requirement that we obtain a royalty or license agreement to continue
using the technology in issue. Such royalty or license agreements might not be
available to us on acceptable terms, or at all, resulting in serious harm to
our business. In this regard a group of companies have formed an organization
called MPEG-LA to enforce the rights of holders of patents covering aspects of
MPEG-2 video technology. We have been asked by MPEG-LA to enter into a license
agreement with them. We have not entered into such an agreement with MPEG-LA,
though we are continuing to evaluate the situation. The cost to us of such a
license cannot be estimated at this time.
Because a majority of our products operate only on Macintosh computers,
-----------------------------------------------------------------------
the potential success of our products is tied to the success of this platform.
- ------------------------------------------------------------------------------
Many of our current products operate on Macintosh computers manufactured
by Apple Computer. If Macintosh computers become in short supply, sales of our
products will likely decline. If there is a decrease in the use of the
Macintosh as a computing platform in the professional and corporate audio and
video markets, there will likely be a decrease in demand for our products. If
there are changes in the operating system or architecture of the Macintosh, it
is likely that we will incur significant costs to adapt our products to the
changes.
In April 2000, Apple Computer announced the acquisition of the DVD
authoring business of Astarte Gmbh. Prior to the acquisition, Astarte sold a
DVD authoring system that competed primarily with our DVD
27
Fusion product. In January 2001 Apple announced two new DVD authoring products,
which we presume are based on Astarte's technology. The first product, iDVD, is
intended for consumer users and we believe will compete with MyDVD and DVDit!.
The second product, DVD Studio Pro, is intended for professional users, and we
believe will compete with DVDit!-PE, DVD Fusion and ReelDVD. Apple also
announced the availability of aggressively priced DVD recorders with certain
models of the Macintosh personal computer. At this time the impact of Apple's
announcements on our business is unclear, and it is possible that some or all
of Apple's product offerings will significantly reduce demand for our products.
Some of our competitors possess greater technological and financial
-------------------------------------------------------------------
resources than we do.
- --------------------
There is a substantial risk that competing companies will produce better
or more cost-effective products, or will be better equipped than we are to
promote them in the marketplace. Please see our discussion concerning Apple
Computer, above. Other competitors who have announced or are delivering
products which compete with our products include MGI, Pinnacle, Roxio, Spruce
Technologies and Ulead. In addition, other companies with greater financial and
technological resources may be interested in entering the growing consumer
business for DVD.
We have little ability to reduce expenses to compensate for reduced sales.
-------------------------------------------------------------------------
We tend to close the greatest number of sales in the last month or last
weeks of a quarter and we generally do not know until quite late in a quarter
whether our sales expectations for the quarter will be met. Because most of our
quarterly operating expenses and our inventory purchasing is committed prior to
quarter end, we have little ability to reduce expenses to compensate for
reduced sales.
For example, in the fiscal quarter ending December 31, 2000, we
experienced a significant slowdown of demand for our professional DVD products
in the last month of that quarter, particularly in the North American and
Japanese markets. Although we attempted to control expenses in the face of this
slowdown, the changes we were able to make were quite small, leading to a
significant operating loss for the quarter.
Approximately 10% of our revenue derives from sales to a single company
-----------------------------------------------------------------------
and another 12% was derived from sales to a large distributor.
- -------------------------------------------------------------
During the last three fiscal years, 1999, 2000 and 2001, between 7% and
11%, of our revenue was derived from sales of audio processing subsystems to
Discreet Logic. During the fiscal years 2000 and 2001, an additional 10% and
12%, respectively, of our revenue was derived from sales to our Japanese
dealer, Sanshin Electronics Company. A decrease or interruption in either
Discreet Logic's or Sanshin's business or their demand for our products would
cause a significant decrease in our revenue.
A significant portion of our revenue derives from sales made to foreign
-----------------------------------------------------------------------
customers located primarily in Europe and Japan.
- -----------------------------------------------
Revenue derived from these customers accounted for approximately 47% of
our revenues in fiscal year 2000 and 2001. These foreign customers expose us to
the following risks, among others:
. currency movements in which the U.S. dollar becomes significantly
stronger with respect to foreign currencies, thereby reducing relative
demand for our products outside the United States;
. import and export restrictions and duties;
. foreign regulatory restrictions, for example, safety or radio
emissions regulations; and
. liquidity problems in various foreign markets.
The issuance of stock pursuant to the Daikin Acquisition Agreements will
------------------------------------------------------------------------
dilute the relative ownership of existing common stockholders and could result
- ------------------------------------------------------------------------------
in lower market price for our stock.
- -----------------------------------
The issuance of 395,000 shares of common stock to Daikin, the issuance of
100,000 shares of common stock to Digitek and the issuance of up to 850,000
shares of Common Stock to Daikin upon conversion of Preferred Stock now or in
the future, will have a dilutive impact on our security holders. For example,
based upon the number of shares
28
of common stock outstanding on April 30, 2001, conversion of 850,000 shares of
preferred stock into common stock would dilute our shareholders by 6%.
Additional sales of stock to Kingsbridge will dilute the relative
-----------------------------------------------------------------
ownership of existing common stockholders and could result in lower market
- --------------------------------------------------------------------------
price for our stock.
- --------------------
Under the equity line agreement with Kingsbridge we have the right to sell
common stock to Kingsbridge in an amount up to 19.9% of our outstanding common
stock over the two year period beginning November 11, 2000. As a result, our
net income or loss per share could be significantly affected in future periods
causing a reduction in the market price of our common stock.
29
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk is limited. All of our international sales are
denominated in US dollars with the exception of the payments made to us by
Daikin pursuant to the Distribution Agreement entered into on February 27, 2001
and payments made to Daikin by us pursuant to the Consulting Agreement entered
into on February 27, 2001. See Note 11 of Notes to Financial Statements. We do
not engage in any hedging activities.
We do not use derivatives or equity investments for cash investment
purposes. Cash equivalents consist of short-term, highly-liquid investments
with original maturities of three months or less and are stated at cost which
approximates market value. Cash equivalents consist of money market funds.
30
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Report of Independent Auditors, Financial Statements and Notes to Financial
Statements follow on pages 32 through 48.
31
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Sonic Solutions:
We have audited the accompanying balance sheets of Sonic Solutions as of
March 31, 2000 and 2001, and the related statements of operations,
shareholders' equity and cash flows for each of the years in the three-year
period ended March 31, 2001 and the related financial statement schedule. These
financial statements and financial statement schedule are the responsibility of
Sonic Solutions' management. Our responsibility is to express an opinion on
these financial statements and financial statement schedule based on our
audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Sonic Solutions as of March
31, 2000 and 2001 and the results of its operations and its cash flows for each
of the years in the three-year period ended March 31, 2001, in conformity with
accounting principles generally accepted in the United States of America. Also
in our opinion, the related financial statement schedule, when considered in
relation to the basic financial statements taken as a whole, presents fairly,
in all material respects, the information set forth therein.
/s/ KPMG LLP
San Francisco, California
May 3, 2001 except as to note 6,
which is as of June 18, 2001
32
FINANCIAL STATEMENTS
SONIC SOLUTIONS
BALANCE SHEETS
(in thousands, except share and per share amounts)
March 31
----------------
2000 2001
------- -------
Assets
Current assets:
Cash and cash equivalents................................... $ 5,179 1,616
Accounts receivable, net of allowance for returns and
doubtful accounts of $930 and $1,005 at March 31, 2000 and
2001, respectively......................................... 4,635 4,185
Inventory................................................... 945 492
Prepaid expenses and other current assets................... 425 448
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Total current assets....................................... 11,184 6,741
Fixed assets, net............................................ 1,515 1,333
Purchased and internally developed software costs, net....... 1,876 3,094
Other assets................................................. 393 570
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Total assets............................................... $14,968 11,738
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Liabilities And Shareholders' Equity
Current liabilities:
Accounts payable and accrued liabilities.................... $ 4,306 4,621
Deferred revenue and deposits............................... 1,224 1,595
Subordinated debt........................................... 600 57
Current portion of obligations under capital leases......... 78 10
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Total current liabilities.................................. 6,208 6,283
Obligations under capital leases, net of current portion..... 10 --
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Total liabilities.......................................... 6,218 6,283
Commitments and contingencies
Shareholders' Equity
Convertible preferred stock, no par value, 10,000,000 shares
authorized: 155,544 and 700,000 shares issued and
outstanding at March 31, 2000, and 2001, respectively...... 506 1,750
Common stock, no par value, 30,000,000 shares authorized;
12,050,214 and 13,056,646 shares issued and outstanding at
March 31, 2000 and 2001, respectively...................... 27,083 28,399
Accumulated deficit......................................... (18,839) (24,694)
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Total shareholders' equity................................. 8,750 5,455
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Total liabilities and shareholders' equity................. $14,968 11,738
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See accompanying notes to financial statements
33
SONIC SOLUTIONS
STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
Years Ended March 31,
-----------------------
1999 2000 2001
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Net revenue........................................... $21,899 20,827 16,519
Cost of revenue....................................... 9,547 8,992 5,892
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Gross profit.......................................... 12,352 11,835 10,627
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