Back to GetFilings.com
FORM 10-K
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
[X] ANNUAL REPORT PURSUANT TO SECTION 13
OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
[ ] TRANSITION REPORT PURSUANT TO SECTION 13
OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File No. 000-22023
Macrovision Corporation
(Exact name of registrant as specified in its charter)
DELAWARE 77-0156161
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
2830 De La Cruz Boulevard
Santa Clara, California 95050
(Address of principal executive offices) (Zip code)
(408) 743-8600
(Registrant's telephone number including area code)
Securities registered under Section 12(b) of the Exchange Act: None.
Securities registered under Section 12(g) of the Exchange Act: Common
Stock, $0.001 par value.
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months
(or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein and will not be contained, to the best
of the Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
form 10-K. [ X ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes X No
--- ---
As of March 25, 2003, the aggregate market value of the voting and non-voting
common equity held by non-affiliates of the registrant, based on the closing
price for the registrant's common stock on that day, was approximately
$662,748,654.75.
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date.
As of March 25, 2003, there were 48,553,015 shares of the Registrant's Common
Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Certain exhibits hereto have been specifically incorporated by reference herein
in Item 13 under Part III hereof. Certain portions of registrant's definitive
Proxy Statement, which will be filed with the Securities and Exchange Commission
in connection with the registrant's annual meeting of stockholders to be held on
May 27, 2003, are incorporated by reference in Items 10-13 of Part III hereof.
MACROVISION CORPORATION
FORM 10-K
INDEX
PART I
ITEM 1. BUSINESS...................................................................................... 1
ITEM 2. PROPERTIES.................................................................................... 30
ITEM 3. LEGAL PROCEEDINGS............................................................................. 30
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........................................... 32
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS...................................... 32
ITEM 6. SELECTED FINANCIAL DATA....................................................................... 33
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS......... 34
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.................................... 49
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................................................... 49
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES......... 49
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS.............................................................. 50
ITEM 11. EXECUTIVE COMPENSATION........................................................................ 50
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................................ 50
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................................................ 50
ITEM 14. CONTROLS AND PROCEDURES....................................................................... 50
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K............................... 51
SIGNATURES........................................................................................... 54
DISCUSSIONS OF SOME OF THE MATTERS CONTAINED IN THIS ANNUAL REPORT ON FORM
10-K FOR MACROVISION CORPORATION ("MACROVISION," "WE" OR "US") MAY CONSTITUTE
FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE SECTION 27A OF THE
SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES AND
EXCHANGE ACT OF 1934, AS AMENDED, AND AS SUCH, MAY INVOLVE RISKS AND
UNCERTAINTIES. SOME OF THESE DISCUSSIONS ARE CONTAINED UNDER THE CAPTIONS "ITEM
1. BUSINESS" AND "ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS." WE HAVE BASED THESE FORWARD-LOOKING
STATEMENTS ON OUR CURRENT EXPECTATIONS AND PROJECTIONS ABOUT FUTURE EVENTS,
WHICH INCLUDE IMPLEMENTING OUR BUSINESS STRATEGY, DEVELOPING AND INTRODUCING NEW
TECHNOLOGIES, OBTAINING AND EXPANDING MARKET ACCEPTANCE OF THE TECHNOLOGIES WE
OFFER, AND COMPETITION IN OUR MARKETS.
IN SOME CASES, YOU CAN IDENTIFY THESE FORWARD-LOOKING STATEMENTS BY
TERMINOLOGY SUCH AS "MAY," "WILL," "SHOULD," "EXPECT," "PLAN," "ANTICIPATE,"
"BELIEVE," "ESTIMATE," "PREDICT," "POTENTIAL," "INTEND," OR "CONTINUE," AND
SIMILAR EXPRESSIONS. THESE STATEMENTS ARE BASED ON THE BELIEFS AND ASSUMPTIONS
OF OUR MANAGEMENT AND ON INFORMATION CURRENTLY AVAILABLE TO OUR MANAGEMENT. OUR
ACTUAL RESULTS, PERFORMANCE AND ACHIEVEMENTS MAY DIFFER MATERIALLY FROM THE
RESULTS, PERFORMANCE AND ACHIEVEMENTS EXPRESSED OR IMPLIED IN SUCH
FORWARD-LOOKING STATEMENTS. FOR A DISCUSSION OF SOME OF THE FACTORS THAT MIGHT
CAUSE SUCH A DIFFERENCE, SEE "ITEM 1. BUSINESS - RISK FACTORS."
PART I
ITEM 1. BUSINESS.
Macrovision Corporation, a Delaware corporation founded in 1983, develops
and licenses rights management and copy protection technologies. Our customers
include major Hollywood studios, independent video producers, enterprise and
consumer software vendors, music labels, digital set-top box manufacturers and
digital pay-per-view ("PPV") network operators. We provide content owners with
the means to market, distribute, manage and protect video, software and audio
content.
Our business originated in video copy protection. Our technology has been
used to copy protect over 3.6 billion videocassettes worldwide since 1985. Since
1997, we have expanded the application of our copy protection technology into
the DVD and digital set-top box ("STB") and personal video recorder ("PVR")
platforms. Most Motion Picture Association of America ("MPAA") studios use our
video copy protection technology to protect some or all movie releases on
videocassette or DVD. Our customers include Disney, Paramount, Columbia TriStar
(Sony), Twentieth Century Fox, Universal Studios, Warner Brothers and
DreamWorks. We believe that our technology is accepted as the de facto industry
standard for analog video copy protection.
We are also in the business of consumer software copy protection. We offer
CD-ROM copy protection and digital rights management ("DRM") technologies to a
variety of software publishers in the PC games, education, information
publishing, and desktop applications software markets.
Our Enterprise Software Division provides electronic license management
software to software and systems vendors and their enterprise customers. We
believe Macrovision is the clear leader in this field, with approximately 1,000
customers under maintenance. The Enterprise Software Division was previously
named the Globetrotter Software Division, formed after our August 2000
acquisition of Globetrotter Software, Inc.
We have recently expanded our business into copy protection,
authentication, and rights management technologies for music CDs. In November
2002, we acquired the assets of Midbar Tech (1998) Ltd. and entered into an
agreement to acquire certain assets from TTR Technologies, Inc. in order to
extend our product portfolio and build our customer base. We expect this
transaction to close in the second quarter of 2003, subject to certain
conditions being met.
We have built, and continue to add to, a large patent portfolio that helps
differentiate our products and is important to our license driven business
model. We generate recurring revenues from a variety of sources by licensing the
use of our patented technologies. In our video copy protection business,we
receive unit-based royalties for copy-protected videocassettes, DVDs, set-top
boxes and personal video recorders. We obtain transaction or use-based royalties
from digital satellite/cable network operators for copy protected PPV movies,
and up-front and annual license fees from DVD and set-top box hardware
manufacturers, and digital satellite/cable network operators. In our software
businesses, we receive unit-based royalties on CD-ROMs, a combination of
time-based licenses and perpetual licenses for our DRM and electronic license
management ("ELM") technologies, and recurring fees for maintenance. In our
music business we receive unit-based royalties for copy-protected music CDs.
1
To further expand our business, we have made strategic investments in
companies that have complementary technologies or intellectual property. Our
largest investment is in Digimarc Corporation ("Digimarc"), a leading digital
watermarking technology company. Over the past 2 years we have partnered with
Digimarc and 5 other companies in the Video Watermarking group to develop what
we intend to be an industry standard copy protection solution to address
next-generation, digital-to-digital copying. For additional information, see the
"Strategic Investments" section on page 16. We intend to continue to evaluate
and pursue additional strategic relationships and acquisitions that are
complementary or extensible to our existing technologies and served markets.
We own or have rights to various copyrights, trademarks and trade names
used in our business. These include Macrovision(R), GLOBEtrotter(R), FLEXlm(R),
SafeDisc(R), SafeCast(R), Colorstripe(TM), SafeAudio(TM), GTlicensing(TM),
SAMsuite(TM), FLEXbill(TM), MacroSAFE(TM), SafeWrite(TM), SafeAuthenticate(TM),
SafeDVD(TM), SafeScan(TM), and Cactus Data Shield(TM) ("CDS").
A copy of this annual report on Form 10-K, as well as our quarterly reports
on Form 10-Q, current reports on Form 8-K and all amendments to these reports
are available, free of charge, through our Internet website at
www.macrovision.com under the heading "Investors" as soon as reasonably
practicable after we file such material electronically or otherwise furnish it
to the Securities and Exchange Commission. The reference to our Internet website
does not constitute incorporation by reference of the information contained on
or hyperlinked from our Internet website and should not be considered part of
this document.
INDUSTRY BACKGROUND
The industry shift towards digital media renders content and copyright
owners increasingly vulnerable to unauthorized use of their content. Consumers'
ability to make unauthorized copies of video, audio and software content has
increased due to the proliferation of inexpensive, easy-to-use devices, such as
VCRs, CD and DVD recorders, audio CD recorders and personal video recorders that
allow in-home copying of videocassettes, DVDs, digital PPV/VOD programs,
CD-ROMs, desktop software, and audio CDs. As technological advances facilitate
digital copying at declining prices, motion picture studios, music labels and
software publishers have become more concerned with protecting their
intellectual property. Independent software vendors ("ISVs") and systems vendors
are similarly concerned about unauthorized or illicit use of their software, be
it in the enterprise environment (where license parameters may be ignored) or at
home (where PC software may be copied and redistributed).
Content owners lose billions of dollars every year to casual copying and
professional or bootleg piracy. The latest data available from the Motion
Picture Association of America estimates that the U.S. motion picture industry
loses in excess of $3 billion annually due to packaged media piracy. In
addition, the International Intellectual Property Alliance ("IIPA") estimated
that copyright piracy around the world inflicts $20-$22 billion in annual losses
to the U.S. copyright industries. We believe that a substantial portion of these
losses arise from casual consumer copying or unauthorized use of software. This
is the focus for our technology.
As a result, a number of government and legislative initiatives have been
enacted in recent years to encourage technologies that protect the rights of the
content owners.
In the United States, Congress enacted the Digital Millennium Copyright Act
in October 1998. This law requires all VCRs to comply with analog copy
protection technologies that are in widespread use, such as those covered in our
patents, beginning in May 2000. Recent effectiveness tests conducted by us in
the U.S. and by an independent third party in Europe in September 2000 and
August 2001 showed that over 95% of the VCRs manufactured in the U.S. and Europe
since 1999 comply and respond to our anticopy process. The Act includes a clause
that outlaws all circumvention devices and technologies that could be used to
defeat any type of copy protection technology. Based on recent tests of new DVD
recorder devices, we believe that manufacturers have designed them so they will
not record analog input that is Macrovision-protected. Hence, our technology
also prevents copying on this platform. The U.S. law is based on a set of
guidelines for amending basic copyright laws to deal with the protection of
digital media. The guidelines were adopted in 1996 by the World Intellectual
Property Organization, an agency of the United Nations.
The European Union has proposed a similar EU-wide copyright directive,
which we believe includes a provision aimed at controlling hardware and software
circumvention devices and technologies. Individual countries' legislatures are
currently discussing these new copyright initiatives.
2
In Japan, a revised copyright law that went into effect in October 1999
prohibits the sale, manufacture, and import of circumvention devices. The Japan
Industry Standard requires all digital recording devices to be responsive to
analog copy protection technologies that utilize automatic gain control
techniques, such as those covered by our patents.
We have four divisions, which are: the Video Technology Division, the
Enterprise Software Division, the Consumer Software Division and the Music
Technology Division. These four divisions are described in more detail below.
VIDEO TECHNOLOGY DIVISION
VHS COPY PROTECTION. Motion picture studios wish to maximize the economic
value from each feature film or other video program over its copyright life.
Independent studies show that studios and video retailers lose VHS and DVD
revenues when consumers make copies of movies, whether from home video or PPV or
Video-On-Demand ("VOD") releases. Kagan World Media estimated that over 59% of
all households in the United States now own two or more VCRs. These households
are capable of making unauthorized copies of prerecorded videocassettes. Because
over 90% of all U.S. households own at least one VCR,any of these households
that also owns a DVD player or a digital PPV set-top box ("STB") can make high
quality VHS copies directly from their DVD players or set-top boxes, unless
programs are copy protected. Even with the focus on digital media andgrowth in
DVD, VCR sales remain strong as prices fall and as DVD/VCR combination units
become more popular. We believe there are over 700 million VCRs in use
throughout the world, and with continued shipments of VCR devices to the market,
VCRs will remain a home copying threat to video content owners for many years to
come.
DVD-TO-VHS COPY PROTECTION. DVD hardware and media became commercially
available in the United States in 1997 and, through the end of 2002,
approximately 56.5 million DVD playback devices have been sold to consumers in
the U.S., according to the DVD Entertainment Group ("DEG") and Consumer
Electronics Association ("CEA"). The rapid growth of the DVD format presents
major revenue opportunities for the studios, as well as serious copy protection
concerns. Without effective copy protection, any one of the approximately 170
million VCRs in use in the U.S. (or 600 million VCRs throughout the world) can,
when combined with a DVD playback device, make videocassette copies of a
non-copy protected DVD. These copies are almost equal in quality to
professionally prerecorded videocassettes.
RECORDABLE DVD COPY PROTECTION. 2002 represented the year in which DVDs
supplanted the VHS as the preferred home video distribution medium. Adams Media
Research reported that consumers spent more than $12 billion last year to own
movies, with DVD outselling VHS two to one. Understanding & Solutions Ltd.
estimates that approximately 1.1 billion DVD-Video discs were shipped to retail
worldwide in 2002, representing an 85% growth over 571 million DVD-Video discs
worldwide in 2001. They project a 28.5% annual increase to 1.3 billion discs in
2003. According to DEG and CEA, there are currently more than 95 million DVD
playback devices in American homes, including stand-alone players, DVD-ROM
drives and DVD-capable videogame consoles, with more than 10 million homes with
two or more DVD-capable devices. All of these devices have analog video outputs
that connect to TV sets.
Virtually 100% of DVD playback devices sold and in use since the DVD format
introduction to the market in 1997 in North America, Western Europe and Japan
are designed to output Macrovision copy-protected analog video if the device
plays a Macrovision copy-protected original DVD disc. These are the major
regions in which the respective countries comply with the 1996 World
Intellectual Property Organization ("WIPO") Copyright Treaty and the WIPO
Performances and Phonograms Treaty. All DVD recording devices that we have
tested to-date do not make a digital DVD copy from the analog video output of a
compliant DVD playback device when playing a copy-protected DVD disc. Since
almost all the installed DVD playback devices only have an analog output, this
means that Macrovision's copy protection technology inhibits both VHS and DVD
copying.
VOD AND PPV COPY PROTECTION. Digital PPV/VOD services enable consumers to
purchase and view movies and other programming in their homes through cable or
satellite systems. Studios have realized the importance of copy protection in
digital PPV/VOD networks, and many of them have required digital PPV/VOD system
operators to install copy protection capability in their digital set-top boxes.
Macrovision's technology enables consumers to view PPV/VOD programs but
inhibits unauthorized copying or significantly distorts unauthorized copies of
the program when copies are attempted by both DVD and VHS recording devices. To
date, Macrovision's copy protection technology has been embedded in over 100
million digital STBs worldwide, representing nearly 90% of total digital STBs
deployed. Our technology is dormant until it is activated by
3
system operators for specific PPV or VOD movies. For the past 3 years, our video
copy protection technology has been activated by PPV system operators in the UK
and Japan only,even though there are approximately 40 million digital
cable/satellite PPV subscribers with access to PPV/VOD in the U.S.
VOD is an emerging service, with approximately 8 million U.S. households
currently enabled to view VOD, and an estimated 30 million expected to be VOD
ready by 2005. Macrovision is in the process of negotiating agreements with
several major MPAA studios for activating copy protection for VOD services in
the U.S.
ENTERPRISE SOFTWARE DIVISION
Software vendors who sell to enterprise customers are vulnerable to
unauthorized use of their software. Large organizations, which typically support
many end-user applications, may inadvertently allow users to run applications
beyond the scope of or the term of their licenses; in other words, users may be
obtaining "free" use of the software vendor's application. In a weak economic
climate, it may be crucial for independent software vendors ("ISVs") to ensure
they are compensated for all software usage. They may also choose to restructure
their offerings to better match the evolving licensing and pricing needs of
their customers. Electronic License Management ("ELM") is a solution to this
problem, and although many ISVs use their own, internally developed license
management software, we believe that ISVs are increasingly recognizing that this
is not their core competency and will opt to purchase a third-party solution,
such as our FLEXlm technology. In September 2002, the International Data
Corporation forecast that while $90 billion of software uses electronic license
management today, this number is expected to grow at a 20% compounded annual
growth rate to reach $186 billion by 2006. We believe that we are positioned to
benefit from this market growth due to our current market leadership, installed
base of customers and broad product set.
CONSUMER SOFTWARE DIVISION
With the proliferation of inexpensive high capacity CD-ROM burners, and the
increase of high bandwidth Internet connections to the home and small office,
individual consumers now have the means to easily copy and distribute
unauthorized desktop software copies on a broad scale. In fact, unauthorized
downloads of application and entertainment software frequently meet or exceed
the volume of downloads of music from Internet file sharing services. As a
result, application software and interactive entertainment (games) software
companies are facing unprecedented loss of revenues due to unauthorized consumer
copying of CD-ROM software and unauthorized file sharing over the Internet.
The rapid expansion of high bandwidth Internet connections for consumers
and small businesses may result in the adoption of new licensing (subscription,
rental, etc.) and distribution models for software. We believe this has created
a large market opportunity for our digital rights management and copy protection
solutions.
MUSIC TECHNOLOGY DIVISION
The music industry is at a digital crossroads. Music industry unit (CD)
sales have been falling approximately 10% year-over-year for the past two years,
according to the International Federation of Phonographic Industries ("IFPI").
The continued decline was attributed to the high penetration of personal
computer-based CD-burners, proliferation of peer-to-peer file sharing services
and the lack of commercially viable copy protection and DRM technologies.
Approximately 40% of recordings sold worldwide are reportedly illegal copies,
resulting in an estimated $4.3 billion of lost industry sales in 2001 alone,
according to IFPI's "Music Piracy Report 2002 and 2001." In addition,
peer-to-peer file sharing of ripped music continues unabated in the
"post-Napster" era. IFPI estimated that, in 2001, approximately 99% of music
files available on the Internet were unauthorized. In May 2002, IFPI estimated
there were approximately 3 million users and 500 million files available for
copying at any one time on all of the peer-to-peer services worldwide. There are
approximately 200,000 Web and FTP sites hosting or linking to some 100 million
unauthorized recorded music files.
Consequently, the music industry is pursuing multiple initiatives to
reverse the year over year sales declines, including CD copy protection and
digital rights management technologies. In December 2002, after purchasing the
assets of Midbar Tech (1998) Ltd., we formed the Music Technology Division and
hired many key Midbar managers and employees in order to better address the
needs of the music industry.
4
Since early 2000, music labels have expressed interest in technology that
would prevent the copying of audio CDs to a PC or CD recordable device. Initial
deployment has occurred in Europe and Japan. During 2002, Macrovision estimates
that of the approximately 65 million copy protected CDs produced worldwide in
2002, approximately 60% were distributed in the Asia Pacific region (principally
Japan), 35% in Western Europe, and 5% in North America, South America, and the
rest of the world combined.
In January 2003, Microsoft officially announced its "second session" DRM
system for the music industry, called "Windows Media(R) Data Session Toolkit."
We are working with two of the five major music labels and with Microsoft to
integrate Windows Media Data Session Toolkit capabilities into our latest Cactus
Data Shield product, CDS-300(TM). This will enable music files to be transferred
in a secure manner from a CDS-300 protected CD to a Windows personal computer
for subsequent export to portable devices and utltimately to enable burning a
copy-protected second generation CDs. Our proprietary disc-based local
authentication process (derived from our SafeDisc(R) technology) ensures that
consumers can only transfer these second session music files to their personal
computer if they are in possession of an original CD.
MACROVISION SOLUTIONS
We develop and market a broad array of proprietary rights management and
copy protection technologies. We offer video copy protection technologies that
address the video content protection needs of motion picture studios and other
content owners, program distributors, and cable and satellite PPV amd VOD system
operators. We provide ELM and electronic license delivery ("ELD") solutions to a
range of software vendors, including application developers, computer systems
suppliers and embedded software vendors. We also supply software asset
management technologies to enable end-user organizations to manage third-party
application software usage. We offer CD-ROM copy protection and rights
management technologies to a variety of software publishers in the PC games,
home education, information publishing, and desktop applications software
markets. We also offer technologies to prevent the unauthorized copying of music
CDs.
VIDEO TECHNOLOGY DIVISION
Our video copy protection technologies allow consumers to view programming
stored on prerecorded videocassettes, DVDs or transmitted as digital PPV or VOD
programs via cable or satellite, but deter unauthorized consumer copying of such
programming on both VCRs and recordable DVD devices. Videocassettes are encoded
with our video copy protection signal as they are manufactured. Our licensed
copy protection signal generator equipment is installed in 237 commercial
duplication facilities in 36 countries around the world. The unique patented
aspects of our copy protection signal are transparent to an analog TV set, but
are disruptive to the recording circuits of VCRs and act to turn off the
recording operation of recordable DVD devices. The result is that videocassettes
and DVDs that are encoded with our anticopy process will play normally on an
analog TV set, but will cause generally unwatchable copies to be made on the
vast majority of VCRs, and will shut down the analog-to-digital recording
circuits of DVD recording devices. Our patented technology takes advantage of
the differences in TV signal processing circuits, VCR playback circuits, and VCR
recording circuits without the need for the installation of any Macrovision
components in VCRs or DVD recording devices. However, both the DVD and VCR
recording devices do need to be manufactured in accordance with the guidelines
of the Digital Millennium Copyright Act with respect to responding to
Macrovision copy protected analog inputs.
In the DVD and digital PPV markets, we have implemented an enhanced version
of our video copy protection technology. By utilizing another copy protection
component, called Colorstripe(TM), we have made it more difficult for a casual
copier to defeat or circumvent our technology. In these digital video
applications, the copy protection is applied within the consumer device. The
copy protection signal generator is part of an integrated circuit that converts
digital video to analog video for output to a standard TV set, VCR, or DVD
recording device. The copy protection circuits remain dormant until activated by
data commands, which are either embedded in the DVD disc or are sent along with
the PPV movie transmission to the subscriber's set-top box or personal video
recorder. Macrovision's technology is licensed to 271 DVD manufacturers, 343 DVD
authoring houses, 98 replication facilities, 68 digital set-top box
manufacturers and 58 semiconductor component suppliers worldwide.
5
ENTERPRISE SOFTWARE DIVISION
Macrovision provides a complete electronic license management solution,
ranging from core software toolkits that software vendors incorporate into their
products to enable flexible licensing, to license fulfillment servers, to
end-user monitoring applications, and to worldwide professional services teams
that help companies follow best practices and integrate the preceding offerings
into various back office systems.
Our FLEXlm(R) licensing system enables software vendors to offer multiple
licensing models, and to monitor the usage and enforce compliance with license
terms in an enterprise-wide intranet, across an extranet or the public Internet,
or within an application service provider ("ASP") environment. Once FLEXlm is
integrated into the software product, the product can be delivered across the
Internet, as well as through more traditional media, such as CD-ROM.
Our GTlicensing(TM) application is an electronic license creation,
distribution, and tracking tool for software vendors, allowing vendors to ship
and track electronic licenses online without direct human intervention. The
system supports multi-tier software distribution, including the capability for
third party distributors to sell software from participating vendors and
allowing end-users to receive their electronic licenses across the Internet.
Our FLEXbill(TM) technology provides usage data to software vendors from
their participating customers. FLEXbill usage data enables pay-per-use billing
and can be used to automatically implement a new set of licensing policies
(e.g., metered usage) more accurately matched to each customer's needs. Software
vendors use FLEXbill to tailor product offerings to each customer and to invoice
for the usage of this portfolio based on an authenticated usage report.
Our SAMsuite(TM) offering is a software asset management solution, designed
for end-user companies that purchase large amounts of software from third
parties. SAMsuite captures and analyzes software usage data to help users
maximize their return on investment, and allocate related costs by project,
department or user, and administers license servers over global networks.
CONSUMER SOFTWARE DIVISION
Our SafeDisc(R) technology is designed to prevent the copying of CD-ROM
computer software by encrypting executable files, embedding an authenticating
digital signature and adding multi-layered anti-hacking software. This is a
proprietary software-based copy protection solution that does not require any
changes to standard PC or CD-ROM hardware. Because SafeDisc is designed to
operate while the disc is in the CD-ROM drive, it is ideally suited to PC games
and education software. The technology is licensed directly to software
publishers, and to mastering and replication facilities that embed our patented
digital signature in a CD-ROM during the manufacturing process. SafeDisc was
introduced in September 1998, has been licensed to approximately 120 replicators
worldwide, and is estimated to have been used on more than 150 million CD ROMs.
Our SafeCast(R) family of digital rights management products is designed to
provide software publishers with control over the distribution and usage of both
packaged media and Internet-delivered software or licenses. It enables software
publishers to establish a variety of license terms, which persistently govern
the use of the software. These license terms can be used to manage every stage
of a software product's life cycle - from pre-release software, through trial
evaluations, and finally commercial distribution resulting in rental, purchase,
or subscriptions.
Our SafeWrap(TM) product is a post-development encryption wrapper for
Microsoft Windows' compatible software and is based upon technologies we
developed for our SafeDisc product. We refer to it as "tamper-proofing" software
because it protects files from being reverse engineered, disassembled, or
modified. SafeWrap also includes an optional application programming interface
("API"), which offers additional security to allow individual functions to be
encrypted and decrypted when being executed.
MUSIC TECHNOLOGY DIVISION
We are actively involved in developing and marketing various technologies
to meet the needs of emerging delivery systems such as downloading and streaming
of media via the Internet, as well as technologies to prevent the unauthorized
6
copying of music CDs. Our current products (CDS-100(TM), CDS-200(TM), and
CDS-300(TM)) provide music labels with the following capabilities:
o First session (Redbook) copy protection, which inhibits the ability to
copy music to a PC for subsequent redistribution on Internet based
file sharing services;
o Encrypted second session (Yellowbook) music files that can play on the
PC, as long as the CD is in the PC CD-ROM drive; and
o DRM technology that enables the second session music files to be
copied to a personal computer hard disk and be managed/played via
Windows Media Player but inhibits subsequent transfer to portable
devices, CD-Rs, and the Internet.
In November 2002, we completed the acquisition of the assets of Midbar
Tech (1998) Ltd. of Israel, and, as a result, acquired what we believe to be the
market leading proprietary CD copy protection and controlled burning
technologies. The CDS-100 and CDS-200 solutions have been used on over 65
million music CDs through 2002. The CDS-300 product is the first integrated
product developed by the combined Midbar and Macrovision engineering staff.
Combining the Midbar patents, Macrovision patents and patents resulting
from our pending acquisition of the intellectual property and other assets of
TTR Technologies, Inc., we believe that we are well positioned to develop and
market unique solutions that meet the needs of the consumer, the artist, the
publisher and the music label. We expect the acquisition of these assets from
TTR to close in the second quarter of 2003, subject to certain closing
conditions being met.
THE MACROVISION GROWTH STRATEGY
LEVERAGE KEY CUSTOMER RELATIONSHIPS. We currently maintain strong
relationships with customers in various industry and market segments, including:
o Video and music content providers such as the major Hollywood studios
and independent movie producers and major record labels;
o Enterprise and consumer software vendors, serving both
business-to-business and business-to-consumer segments;
o Content distributors such as the leading cable and satellite
television system operators; and
o Consumer electronics manufacturers of DVD players, CD and DVD drives,
PVRs, and digital set-top boxes.
We intend to build our business by capitalizing on these customer
relationships and targeting them for delivery of our
existing and future rights management and copy protection technologies.
INTRODUCE NEW PRODUCT APPLICATIONS AND TECHNOLOGIES. Simultaneously, we
intend to develop additional rights management solutions to sell to our
extensive customer base. We have committed significant resources to expand our
technology base, to enhance our existing products, to introduce additional
products and to participate in industry standard-setting efforts and
organizations. We intend to pursue opportunities for rights management, copy
protection and enabling solutions in the following areas:
o Digital video;
o Music CDs;
o Internet downloaded and streamed audio and video files;
o Internet downloaded software files;
o Peer-to-peer file sharing;
o CD-ROM, CD-Rs;
o DVD-ROM, DVD-Rs;
7
o Electronic license management and delivery for enterprise software;
o Software asset management products for enterprise customers; and
o Improved authentication, compression, and encryption technologies.
EXPAND AND PROTECT PATENT POSITION. We believe that our future success
will depend on our ability to continue to introduce proprietary solutions for
rights management and copy protection technologies that can be supplemented by
enabling features that will incent consumers and users to pay for video, audio
and software products, rather than trying to get them for free in an
unauthorized fashion. We have patented many of these proprietary solutions, and
they underpin our strong competitive position and financial model. We have
acquired key software rights management and copy protection patents. We use
patents to limit the proliferation of devices that circumvent our video copy
protection technologies, and we have initiated legal action relating to
infringement of these patents. We intend to continue to obtain patents and to
protect and defend our patented technologies aggressively, including developing
and obtaining patents covering a number of processes and devices that
unauthorized parties could use to circumvent our DRM and copy protection
technologies.
CONTINUE TO MAKE STRATEGIC ACQUISITIONS. We intend to continue to expand
our technology portfolio by pursuing licensing arrangements, joint ventures and
strategic acquisitions of companies whose technologies or proprietary rights
complement our rights management and copy protection technologies.
We have made four acquisitions since 1999. We acquired C-Dilla, Ltd. of
the UK in June 1999 in order to enter the application software copy protection
and DRM business; in August 2000, we acquired Globetrotter Software, Inc., which
provided our enterprise electronic license management and software asset
management business; in October 2000, we acquired Productivity through Software
plc ("PtS") of the UK, which was a distributor of our enterprise software
solutions; and, in November 2002, we acquired the assets of Midbar Tech (1998)
Ltd., which provided us with significant intellectual property and key personnel
skilled in music copy protection and controlled disc burning applications. We
have also entered into a definitive agreement to acquire certain assets of TTR
Technologies, Inc., further enhancing our intellectual property relating to
music copy protection.
TECHNOLOGY LICENSING, SALES AND MARKETING
Technology Licensing. We license our portfolio of rights management and
copy protection technologies. We believe that content owners and software
vendors utilize our solutions to secure their content or software and to ensure
that their end-user customers pay them for the use of such content or software.
We receive royalties and recurring revenues as follows:
o Video and music content owners typically pay us a per-unit licensing fee
for the right to use our proprietary copy protection technologies for DVDs,
videocassettes, and music CDs;
o Enterprise software vendors and enterprise end-user customers pay us a fee
to license our technology using either time-based licenses or perpetual
licenses with annual maintenance fees;
o Consumer software publishers pay us a per-unit licensing fee to use our
technology for CD-ROM copy protection and time-based or perpetual licenses
for our DRM technology;
o Digital set-top box and digital PVR manufacturers license our video copy
protection technologies for an up-front fee and a per-unit royalty;
o Cable and satellite television system operators pay us a one-time license
fee for the right to incorporate our video copy protection technology into
their networks for PPV or VOD services. In addition, we are entitled to
transaction-based royalty payments when copy protection for digital PPV or
VOD programming is activated by system operators; and
o DVD hardware manufacturers (DVD consumer electronic player manufacturers
and PC DVD ROM suppliers) license our technology for an up-front fee and
annual license fee.
SALES AND MARKETING. We market our rights management and copy protection
technologies directly to content owners and independent software vendors in both
the video and software markets. We also license our software asset management
solutions directly to end-user enterprise customers. Our primary sales strategy
is to sell at senior levels,
8
offering worldwide contracts that cover customers' international operations. We
supplement our direct sales efforts with reseller programs and service
partnerships among VHS, DVD, and CD duplicator, replicator and authoring
organizations, and internal professional services, value added reseller, and
systems integrator organizations in our enterprise software business. We also
utilize a variety of marketing initiatives, including trade show participation,
trade advertisements, industry education and newsletters.
Our primary locations for product development, business strategy, and
operations are in our Santa Clara (California) and Woodley (United Kingdom)
offices. We have sales and support operations through our U.S.sales force, and
through our offices in South Ruislip, Woodley and Cheshire in the United
Kingdom; Frankfurt, Germany; Tokyo, Japan; Seoul, Korea; Hong Kong; Taipei,
Taiwan; and Tel Aviv, Israel.
CUSTOMERS
VIDEO TECHNOLOGY DIVISION
VIDEO CONTENT. Our copy protection technology has been applied to more
than 3.6 billion videocassettes worldwide since 1985. Since the inception of DVD
in 1997, our copy protection has been applied to over 1.5 billion DVDs. Our copy
protection technology for videocassettes and DVDs is used by the following
leading major motion picture studios and home video suppliers:
o Artisan Home Entertainment o New Line Cinema
o Buena Vista Home Video (Disney) o Paramount Pictures
o Columbia TriStar Home Entertainment o Twentieth Century Fox Home
(Sony Pictures) Entertainment
o DreamWorks SKG o Universal Studios Home Video
o HBO Home Video (Vivendi)
o Lion's Gate/Trimark Pictures o Warner Brothers Home Video
One customer accounted for more than 10% of Macrovision's net revenues
in 2002. There was no customer that accounted for more than 10% of our net
revenues in 2001. One customer accounted for more than 10% of our net revenues
in 2000. The Motion Picture Association of America ("MPAA") studios as a group
accounted for 42.2%, 33.2% and 24.8% of Macrovision's total net revenues in
2002, 2001 and 2000, respectively.
We also license our video copy protection technology to "Special
Interest" customers that include independent video producers and corporations.
Licensed commercial duplicators act as distributors of our video copy protection
technology to "Special Interest" customers.
PPV/VOD SYSTEM OPERATORS. There are over 20 system operators who have
licensed or specified Macrovision's digital PPV copy protection technology for
incorporation into their networks, including:
o British Sky Broadcasting Group o Optus (Australia)
o BS Conditional Access Systems Co., o Premier (Germany)
Ltd. (Digital BS Broadcast) (Japan)
o DirecTV (North America) o SkyPerfecTV! (Japan)
o DirecTV Latin America o Telewest Communications (UK)
o Korea Digital Broadcast ("KDB") o UPC (Holland)
o NTL o Video Networks Ltd. (UK)
These system operators have paid a one-time license fee to us and have
entered into agreements with us pursuant to which we are entitled to
transaction-based royalty payments at such time as copy protection for digital
PPV or VOD programming is activated. However, only 9 international system
operators have activated Macrovision's copy protection in their networks:
British Sky Broadcasting (UK), Digital BS (Japan), Kingston Communications (UK),
Korea Digital Broadcast (Korea), NTL (UK), SkyPerfecTV! (Japan), Telewest (UK),
Premiere (Germany) and Video Networks Ltd. (UK). U.S. systems operators have not
yet activated copy protection, even though the technology is implemented in
their network infrastructure. Other notable system operators that have not
signed usage license agreements with us, but which are requiring
Macrovision-capable set-top boxes in their networks include: AT&T, Comcast, Cox
from a variety of sourcesEnterprises, Deutsche
9
Telecom, Rogers Cable, Time Warner, UPC and Via Digital. We are in discussions
with a number of major studios to activate VOD copy protection in the U.S.
CONSUMER ELECTRONICS HARDWARE MANUFACTURERS. We believe that our DVD
copy protection technology is currently the only viable digital-to-analog and
analog-to-digital copy protection solution that satisfies the principles
established by the DVD licensing and standards group, and has been tested and
accepted for compatibility with TV sets by leading consumer electronics
companies. As of December 31, 2002, 271 companies that manufacture DVD players
or DVD-ROM drives had signed agreements with us to incorporate our DVD copy
protection technology into their hardware, including both Sony and Microsoft for
their DVD-based game consoles PlayStation(R)2 and Xbox(TM).
Our PPV/VOD copy protection technology is embedded in more than 100
million digital set-top boxes currently in use worldwide, which we believe
represents approximately 90% of all digital set-top boxes. We have licensed our
copy protection technology for digital PPV/VOD to 68 set-top box and 9 PVR
manufacturers, including:
o Acer o Pace Micro Technology
o AT&T Network Systems o Philips Electronics
o Daewoo Electronic Co., Ltd. o Pioneer Electronics
o EchoStar Communications o Scientific-Atlanta
o Hughes Electronics o Sony
o Motorola Broadband o THOMSON Multimedia
We have also authorized 58 semiconductor companies to incorporate our
digital PPV/VOD and DVD copy protection technologies into their semiconductor
and reference designs. These companies generally pay a one-time service fee to
verify correct implementation of our video copy protection technology in
digital-to-analog application specific integrated circuits ("ASICs") that are
embedded in digital set-top boxes and DVD hardware. They are authorized to sell
these Macrovision-capable ASICs to Macrovision-licensed DVD hardware
manufacturers and to Macrovision-licensed digital set-top box and personal video
recorder (sometimes referred to as "digital video recorder") manufacturers.
ENTERPRISE SOFTWARE DIVISION
We believe that FLEXlm, our electronic license management ("ELM")
software, is the industry leader. Worldwide adoption of our ELM technology will
be an important driver of future growth. We have licensed our ELM and electronic
license delivery ("ELD") technologies to more than 2,500 independent software
vendor companies in a range of market segments, including:
o Autodesk o Sun Microsystems
o Cadence Design Systems o Sybase
o Cisco Systems o Synopsys
o Rational Software o Wind River Systems
In addition we have licensed software asset management ("SAM") companion
products to over 500 corporate end-users, which enable these end-users to
deploy, manage, and track the software they have purchased from our software
vendor customers, as well as other third party software vendors. Examples of
such corporate end-user customers include:
o ABB o IBM
o BMW o Lockheed Martin
o Eastman Kodak o Nokia
o Ford Motor Company o Royal Dutch/Shell Group
CONSUMER SOFTWARE DIVISION
We entered the consumer software copy protection market in 1998 with our
SafeDisc product, aimed at those applications that require the CD-ROM to be
inserted in the drive to run the application; typically PC games, and
entertainment applications. In 2001, we extended the SafeDisc market into
professional applications and computer based
10
training and, in 2002, we extended SafeDisc into the Apple Macintosh
environment. We estimate that approximately 150 million CD-ROMs have now been
shipped using SafeDisc.
Our copy protection technology for consumer software is used by leading
software publishers, including the following:
o Activision o Hyperion Solutions
o Apple o MathWorks
o CDV Software Entertainment o Mattel
o Eidos o Microsoft
o Electronic Arts o Take 2 Interactive
o Hasbro (Infogrames) o 3DO
o Havas (Viveni Universal Interactive) o Ubisoft Entertainment
Our consumer software customers have a wide choice of licensed
replicators that they can use throughout the world. Approximately 120
replicators have been licensed and have installed SafeDisc mastering and quality
assurance systems from authorized suppliers of these systems.
In 2002, we experienced continued broad market adoption of our SafeCast
family of digital rights management products. SafeCast enables publishers to
flexibly market, license and protect software products delivered on CD ROMs,
DVDs and via the Internet to increase their revenues. Such customers include:
o Autodesk o Intuit
o BBC o MathSoft
o Electronic Arts o Microsoft
Although SafeCast is a more complex sale to software publishers, with a
longer sales cycle than SafeDisc, we believe that, over time, as Internet
bandwidth increases, there will be increasing demand for this digital rights
management technology.
MUSIC TECHNOLOGY DIVISION
CDS-100 and CDS-200 have been utilized on music CDs by all five major
music labels (i.e., Universal, Warner, Sony, BMG, and EMI) in Europe and/or
Japan, and by Avex, Pony Canyon and others in Japan. As of December 2002, our
CDS technology has been applied to over 65 million music CDs worldwide.
The CDS processor, which our customers use to apply our copy protection
technologies to their CDs, has been installed in 42 manufacturing plants
worldwide, including plants in North America, Europe and Japan.
TECHNOLOGY
VIDEO TECHNOLOGY DIVISION
Macrovision's technology was originally designed to prevent unauthorized
copying of VHS, DVD and PPV/VOD programming to VCRs without impacting the
original playback. An added feature of Macrovision's DVD copy protection
technology is that it helps to prevent DVD-to-DVD copying, as well as DVD-to-VHS
copying. The majority of the recently introduced PVRs, DVD/VCR combo units, DVD
recorders ("DVDRs") and PVR/DVDR combo units comply with the U.S. Digital
Millennium Copyright Act and, as a result, they recognize Macrovision's
proprietary analog copy protection process and disable digital recording on
recordable DVD discs.
Effective video copy protection systems are difficult to develop because
of the need to address the dual requirements of playability and effectiveness.
High playability means that consumers must be able to view the original
copy-protected content using a VCR or DVD and a TV set or projection TV without
the need for any intervening devices, while high effectiveness requires that the
quality of an unauthorized copy must be reduced to such an extent that it loses
its entertainment value. In the tradeoff between effectiveness and playability,
designers of copy protection systems must favor playability while maintaining
effectiveness.
11
VIDEOCASSETTE COPY PROTECTION. Our videocassette copy protection
technology involves the patented technique of inserting a series of electronic
pulses in and around the vertical blanking interval of a standard video signal.
The vertical blanking interval is the blank space between the video fields that
are refreshed at a rate of 60 fields per second. The copy protection pulses are
embedded electronically in the prerecorded content of the videocassettes in the
process of videocassette manufacture. The electronic pulses are not visible in
the television picture. The pulses are intended to affect the automatic gain
control circuit in the recording system of most VCRs, but not to affect a
similar circuit in the television set. Therefore, when the consumer plays a copy
protected prerecorded videocassette, the picture is clean and crisp, but when
the consumer plays an unauthorized copy of that same videocassette, the picture
typically is very distorted and has substantially reduced entertainment value.
Our video copy protection technology is effective against most casual copying,
but generally does not deter professional pirates who use professional
duplication and video processing equipment. Under the U.S. Digital Millennium
Copyright Act of 1998, all VCRs sold in the U.S. after May 2000 are required by
law to respond to our copy protection technology.
DVD AND DIGITAL PPV/VOD COPY PROTECTION. The DVD and digital PPV/VOD
versions of our video copy protection technologies employ both the electronic
pulses used in videocassettes and a second patented copy protection process
called Colorstripe. Colorstripe affects the color playback circuit of a VCR
causing colored horizontal stripes to appear in the picture of an unauthorized
copy. The combination of the two processes provides a higher level of
effectiveness than that provided by either process alone. In addition,
Colorstripe is more effective against circumvention by most "black box"
circumvention devices that were sold in the past. Copy protection is implemented
in DVD and digital PPV applications by embedding a copy protection signal
generator integrated circuit within the DVD player or digital set-top box. The
integrated circuit is activated by copy protection control codes, which are
embedded into the DVD media or the PPV transmission. Once the integrated circuit
is activated, it adds the copy protection signal to the analog output of the DVD
player or digital set-top box. As with videocassette copy protection, consumers
are able to see a clear picture on their television sets, but generally cannot
make a usable videocassette copy on a VCR, and DVD recorders do not make DVD
copies when they sense Macrovision on the input signal.
ENTERPRISE SOFTWARE DIVISION
Software vendors integrate FLEXlm into their products to monitor or
control a customer's compliance with a product's license terms. When selling
their product, software vendors who use FLEXlm define a customer's license
rights in a human readable "license file." The technology generates electronic
license certificates that describe the license rights of software users.
Compliance with those license rights is automatically monitored. The software
vendor may choose to block users from running a product if doing so violates the
license rights, or simply provide notification to the user or system
administrator when license use has exceeded the customer's license rights. This
allows customers to buy and sell software licenses using much more flexible
license terms than traditional one-computer-one-license or site license
approaches. These terms may include floating licenses (where a specific number
of licenses are shared over a network), product suites (where several product
licenses are combined to be licensed as a single product) and demo licenses
(where a prospective customer has full functional use of a product, but the
right to use expires on a specific date).
Independent software vendors integrate flexible electronic licensing
algorithms into their software rather than "hard-coding" license policies into
their products. This avoids the need to change a product's source code and to
support multiple releases when licensing terms change for a product. Marketing,
sales, support or order administration staff define licensing policies in the
human readable text file, without the need for software engineers to make
changes in software. Software vendors can include information identifying the
customer and other purchasing information as part of the license certificate.
This is done so that if the software and license were diverted to another
company, an audit trail is left, making discovery of improper use of the license
far more likely.
Electronic licensing also records the use of software licensing into a
transaction log called the "Report Log." The information in this log is
authenticated and compressed so software vendors and customers can use this
information as a basis for pay-per-use or other usage-based pricing or
licensing. In addition, customers may use this information to better manage
their software assets and to "bill back" software-related costs to different
departments or projects in the company. The SAMsuite product family contains
this functionality.
12
CONSUMER SOFTWARE DIVISION
Each CD-ROM published with the SafeDisc technology is premastered with
encrypted executable files and contains authenticating instructions and a unique
SafeDisc digital signature. The digital signature, which prevents copying by CD
recorders or transfer from a CD-ROM to a hard disc drive, is added to each
original disc during the mastering/replication process. SafeDisc is a
"unilateral" copy protection solution, which means that all of the copy
protection technology resides on the CD-ROM and nothing has to be added to or
changed in the PC. When a user inserts an original SafeDisc-protected disc in a
CD-ROM drive, the authentication software reads the digital signature, allowing
the program to be decrypted and run normally. The digital signature and
authentication process is transparent to the user. If a consumer or pirate uses
a CD recording device or professional mastering equipment to duplicate a CD-ROM
and make an unauthorized copy, SafeDisc is designed to inhibit the transfer of
the digital signature to the copy. If an unauthorized copy is made, decryption
will not take place and the copy will not run.
SafeDisc also contains anti-hacking technology to prevent the compromise
of its security features. Because of our widespread penetration in the PC games'
market, hackers have targeted and cracked several versions of SafeDisc. For us
to continue to be successful in this market, we must continually stay a step
ahead of the hacker community. We release new product versions approximately
three times per year incorporating new anti-hacking features.
Our SafeDisc technology is patent protected, and is compliant with
Philips' worldwide Yellowbook CD-ROM standard. We believe that SafeDisc is the
only copy protection technology that has received Philips' certification for
compliance.
SafeCast is a software DRM system that is used primarily by developers
of applications targeting the consumer and small-office/home-office markets.
SafeCast authenticates the end-user's license by transferring the software
publisher's embedded digital rights management technology from either a CD-ROM
disc or from Internet downloaded software to the user's PC hard drive at the
time the application is initially installed. SafeCast protects the launch of a
licensed application by confirming that the session conforms to the license
terms established by the application's publisher. The publisher establishes
license terms that determine how the application may be used. The combination of
license terms and persistent protection enables publishers to implement new
licensing models such as subscriptions, rentals, and protected pre-release
programs.
MUSIC TECHNOLOGY DIVISION
In the audio CD market, CDS-100 and CDS-200 first session, or Redbook
copy protection technologies were developed by Midbar (now owned by Macrovision)
to prevent consumer electronic device music files (standard, uncompressed music
CD format) from being ripped by PCs. Each of the several CDS-100 and CDS-200
first session copy protection functions (e.g., coding, hiding and timing) is
covered by pending patent applications. Our second session, or Yellowbook
solution, CDS-300, utilizes an authentication scheme based upon our SafeDisc
product described above, which is covered by a patent and a pending patent
application (for disc-based rights authentication). This solution is designed to
interface with third party DRM systems such as Microsoft's Windows Media Player
(and potentially with Real Network's media player and Sony's Open Magic Gate
DRM), and to enable consumers to play copy protected CDs on their PCs, and
ultimately to download music tracks to their PC's hard disc drive and export
tracks to portable player devices.
RESEARCH AND DEVELOPMENT
Our internal research and development efforts are focused on developing
enhancements to existing products, new applications for our current technologies
and new patentable technologies related to our various rights management markets
and copy protection products. Our core competencies are in encrypted software,
electronic license management and license delivery software, anti-hacking
software, digital and analog video and audio engineering, copy protection
engineering, watermarking and CD-ROM architecture. We have acquired other
companies and technologies to supplement our research and development
expenditures.
In 2002, 2001 and 2000, our expenses for research and development were
$11.9 million, $9.3 million and $7.8 million, respectively.
13
INTELLECTUAL PROPERTY RIGHTS
PATENTS ISSUED & Pending. We hold 76 U.S. patents and have 58 U.S.
patent applications pending. Of the issued or allowed patents, 44 relate to our
copy protection technologies, 18 relate to video scrambling, seven relate to
audio scrambling, five relate to electronic license management and two relate to
DRM technology (namely content usage control, tracking, and e-transactions). Of
the pending patent applications, four relate to consumer software copy
protection and six relate to audio copy protection. The last of our issued U.S.
patents expires in 2019. The last of our core group of analog copy protection
patents expires in the year 2017. We have filed numerous applications for
additional claims and improvement patents to extend the current expiration
dates. We also have 515 foreign patents issued and 400 foreign patent
applications pending in 40 countries. Of the issued foreign patents, 399 relate
to our copy protection technologies, 88 relate to video scrambling, 24 relate to
audio scrambling, and three relate to electronic license management and DRM.
CIRCUMVENTION TECHNOLOGY PATENTS. Included in the patents related to our
copy protection technologies are 15 U.S. and 96 foreign patents covering a
number of processes and devices that unauthorized parties could use to
circumvent our video copy protection technologies. We have historically used
these patents to limit the proliferation of devices intended to circumvent our
video copy protection technologies. We have initiated a number of patent
infringement lawsuits against manufacturers and distributors of such devices.
COMPETITION
VIDEO TECHNOLOGY DIVISION
Our video copy protection technologies are proprietary and have broad
international patent coverage. We believe that there are currently no
significant analog video copy protection competitors. We have the only analog
copy protection scheme that has been widely deployed on commercial products that
significantly distorts or inhibits copying by VHS VCRs, DVD recorders and
personal video recorders. Currently, our video copy protection technology is
embedded in nearly 100% of all DVD players and nearly 90% of digital set-top
boxes worldwide. While it is possible that a competitive video copy protection
technology could be developed in the future, we believe it would take years for
the competitive technology to be tested and accepted by hardware manufacturers
and ultimately to begin to be embedded into the consumer electronic devices. By
the time this would happen, it is unlikely any other analog copy protection
technology would displace our copy protection infrastructure and our extensive
video copy protection "ecosystem."
Our technology is designed to inhibit or prevent unauthorized consumer
copying; it is not designed to prevent professional piracy. We believe that our
customers are very concerned with professional piracy of their video, audio and
software products and their need to address professional piracy presents a
certain level of competition to our video copy protection business, to the
extent that some content owners may decide to devote more of their resources to
fighting professional video piracy instead of using our copy protection to deter
unauthorized consumer copying.
In addition, with the increase in online movie and music distribution
over the Internet, other digital content protection or DRM technologies may
present significant competition to our video copy protection business, such as
DRM offerings by Microsoft, RealNetworks and Sony.
ENTERPRISE SOFTWARE DIVISION
Our primary competition in the ELM market currently comes from
independent software vendors who develop their own ELM solutions or electronic
software distribution technology. Other more traditional competitors include
electronic licensing technology vendors (e.g., NetQuartz, Softwrap), as well as
companies that have historically offered hardware dongle products and
supplemented them with ELM offerings (e.g., Rainbow, Aladdin). We believe that
these companies together have penetrated less than 15% of the potential ELM
market. Operating system developers (e.g., Microsoft, Sun) already integrate
limited license management functionality into their products; potentially, they
could expand this functionality, which could pose an increased competitive
threat. Similarly, microprocessor suppliers may choose to integrate rights
management solutions into their products, and software resellers could also
begin to develop their own ELM solutions.
14
CONSUMER SOFTWARE DIVISION
We believe that there are a limited number of competitors in our
SafeDisc consumer software copy protection market, including StarForce
Technologies, a Russian company, and Sony's DADC optical disk manufacturing
subsidiary. We believe we are the market share leader due to our strong
intellectual property position and extensive customer base. There are a limited
number of competitors, including Aladdin and XtreamLok, in our SafeCast digital
rights management market, where we believe we have captured the leading market
share.
It is possible that our own customers may develop software copy
protection technologies on their own. It is also possible that personal computer
operating system and microprocessor companies, like Microsoft and Intel, may
develop or license copy protection modules or rights management systems that are
internal to the PC or other consumer electronic devices. Few of them have made
any significant inroads, with the exception of Microsoft and Real Networks in
the audio DRM space.
MUSIC TECHNOLOGY DIVISION
We believe that there are a limited number of direct competitors in the
audio copy protection and rights management market, including SunnComm, Sony,
and First4Internet, some of which have greater financial and other resources
than we have. To date, taking into account our acquisition of Midbar, we have
captured a significant market share of the CDs produced worldwide to which audio
CD copy protection has been applied. It is important to note that in 2002, less
than 50 million music CDs out of a total of more than 1 billion music CDs
produced included copy protection technology from any supplier, including
Macrovision and Midbar. In January 2003, Microsoft announced the release of its
Windows Media Data Session Toolkit ("WMDST") with a second session DRM solution
that can to be deployed independently of our solutions. The announcement
included SunnComm as the first company to integrate a third party music CD copy
protection technology with Microsoft's WMDST. We believe that SunnComm uses
technology that is competitive with our CDS-100 and CDS-200 technologies. It is
possible that Microsoft may develop or acquire copy protection and rights
management solutions that compete with our offerings.
OPERATIONS AND TECHNICAL SUPPORT
We have technical support and certification operations to support our
DVD manufacturer licensees, set-top box licensees, authorized semiconductor
manufacturers, and our other hardware licensees. We provide technical support
and professional services to our independent software vendor customers during
pre-sale, implementation and maintenance phases of our contracts.
We provide technical support to our videocassette, DVD, music CD,
digital PPV/VOD, ELM and consumer software customers in various ways:
o We support our licensed duplicators and replicators with hardware and
software installation assistance and quality control. In addition, we
support licensed duplicator/replicator sales personnel by providing sales
training and literature, and by participating in trade shows;
o We support the efforts of television, VCR and DVD hardware manufacturers,
digital PPV/VOD system operators and PPV/VOD set-top box manufacturers to
design hardware that properly incorporates our video copy protection
technologies;
o We assist semiconductor manufacturers in incorporating our video copy
protection technologies into a variety of digital video integrated
circuits;
o We regularly test the effectiveness and transparency of our video and audio
copy protection technologies on representative samples of consumer
televisions, VCRs, DVD players and PC drives, and music CD player and
recorder devices to determine whether modifications or enhancements may be
necessary;
o We provide training and professional services to assist our independent
software vendor licensees in wrapping their executables with our SafeDisc
and SafeCast modules;
15
o We provide support and maintenance, training, integration and software
development services to customers incorporating our electronic license
management software (FLEXlm) and electronic license delivery software
(GTlicensing) into their software products;
o We provide training and application support for the SafeDisc and CDS (audio
copy protection and authentication) toolkits; and
o We test for SafeDisc and CDS compatibility and effectiveness with a variety
of PC and CD-ROM drive software and hardware.
We have minimal manufacturing operations. Our strategy is to license our
technologies to third parties that manufacture products or software
incorporating our technologies. Our manufacturing operations are limited to low
volume video and audio copy protection hardware products that require in-house
system integration and quality control efforts.
STRATEGIC INVESTMENTS
We have made strategic investments in the following companies:
DIGIMARC CORPORATION (NASDAQ: DMRC). In December 1997, we made our
initial investment in Digimarc. We made two subsequent investments in June 1999
and October 2000, for a total of $25.3 million. Digimarc completed an initial
public offering in December 1999. As of December 31, 2002, we owned
approximately 11.5% of Digimarc, which translated to a valuation of $22.8
million. During 2002, we determined that the decline in value of Digimarc stock
was other-than-temporary and took a charge to earnings of $1.8 million as a
result.
Digimarc is a leading provider of patented digital watermarking
technologies that allow imperceptible digital code to be embedded in traditional
and digital content, including movies, photographic images and documents such as
financial instruments, passports and event tickets.
TTR TECHNOLOGIES, INC. (NASDAQ: TTRE). In January 2000, we invested $4.0
million to acquire a minority interest in TTR. In addition, we have entered into
an agreement with TTR to jointly develop and market a copy protection product
designed to inhibit casual copying of music CDs using duel-deck CD recorder
systems and personal computer based CD-recordable drives. TTR is a provider of
proprietary digital anti-piracy technologies and products. As of December 31,
2002, we held approximately 10.3% of the outstanding shares of TTR, which
translated to a carrying value of $339,000.
During 2002, we determined that the decline in value of TTR stock was
other-than-temporary and took a charge to earnings of $3.8 million as a result.
In November 2002, we signed an agreement with TTR to acquire patents and
other assets for approximately $5.3 million in cash and the surrender of our
stock in TTR. We expect this transaction to close in the second quarter of 2003.
iVAST. In June 2001, we invested $5.0 million to acquire an ownership
interest in iVAST, a developer of MPEG-4 based solutions for the delivery of
streaming multimedia. The iVAST platform encompasses a full range of
functionality including, authoring, streaming, backend integration, playback and
interactivity. The platform is designed to support a wide range of broadband
enabled information appliances. As of December 31, 2002, we owned approximately
15.6% of the outstanding shares of iVAST.
NTRU CRYPTOSYSTEMS. In August 2001, we invested $1.5 million to acquire
an ownership interest in NTRU Cryptosystems, a developer of security solutions
for emerging consumer markets, providing security solutions in a variety of
software and hardware formats for all major hardware and software environments.
NTRU Cryptosystems is based on a fundamental mathematical innovation, which
makes efficient public key cryptography practical on a scale necessary for
consumer and embedded applications. As of December 31, 2002, we owned
approximately 2.3% of the outstanding shares of NTRU Cryptosystems.
In December 2002, we received information that NTRU Cryptosystems would
be returning cash to investors and suspending business operations. We recorded
an impairment charge of $938,000 in December 2002 to reduce the value of our
investment to $562,000 which is the net realizable value based on the cash we
expect to receive.
16
COMMAND AUDIO CORPORATION, DIGITAL FOUNTAIN AND WIDEVINE TECHNOLOGIES.
We had previously acquired minority equity interests in Command Audio
Corporation, Digital Fountain and Widevine Technologies. During 2002, consistent
with our policy for evaluating recoverability of these investments, we concluded
that impairment of our investments was other-than-temporary. Accordingly, we
wrote off the book value of these investments during 2002 and took an aggregate
charge to earnings of $10.7 million relating to them for the year ended December
31, 2002.
During 2001, consistent with our policy for evaluating recoverability of
these investments, we concluded that impairment of our investments in AudioSoft,
InterActual Technologies, RioPort and SecureMedia was other-than-temporary.
Accordingly, we wrote off the carrying value of these investments during 2001
and took an aggregate charge to earnings of $6.9 million for the year ended
December 31, 2001.
These strategic investments, valued at $28.7 million as of December 31,
2002, represented 8.9% and 16.9% of our total assets as of December 31, 2002 and
2001, respectively. NTRU Cryptosystems and iVAST are privately held companies.
There is no active trading market for their securities and our investment in
them is illiquid. In total we wrote off $17.2 million and $6.9 million
respectively related to impairments that were other-than-temporary for the years
ended December 31, 2002 and 2001. There were no comparable write-offs in 2000.
Looking forward, we may continue to evaluate strategic investment
opportunities on a selective basis that we feel may broaden our market reach or
technology portfolio. We may never have an opportunity to realize a return on
either current or future investments and may be required to write off all or
part of these investments.
EMPLOYEES
As of December 31, 2002, we had 283 employees. Of these employees, 108
are based outside of the U.S. None of our employees is covered by a collective
bargaining agreement or is represented by a labor union. We have not experienced
any organized work stoppages.
We use a variety of incentive programs to motivate our employees,
including annual performance-based bonuses, stock purchase plans, stock options,
special recognition awards, and a package of other benefit programs including a
401(k) plan, medical/dental benefits, compensating time off for community
service and health club and educational reimbursement.
Our engineering teams develop new products and enhance existing
offerings, as well as contribute to our technical due diligence efforts when we
make strategic investments, conclude joint development agreements, or acquire
rights to third party technologies.
Our technical support staff provides customer sales support and conducts
extensive compatibility and effectiveness tests for our various rights
management and copy protection technologies. In addition, this staff runs an
extensive certification lab to confirm that our licensees have implemented our
video copy protection technologies correctly in integrated circuits and DVD or
set-top box hardware.
Our sales and marketing groups include senior executives who manage our
business lines and provide executive level account management to our major
customers. We also have a direct sales staff that works with our content owner
and software vendor customers. Our in-house legal department provides licensing
and patent counsel to our executives.
17
RISK FACTORS
IN ADDITION TO THE OTHER INFORMATION CONTAINED IN THIS ANNUAL REPORT ON FORM
10-K, YOU SHOULD CONSIDER CAREFULLY THE FOLLOWING RISKS. IF ANY OF THESE RISKS
OCCURS, OUR BUSINESS, FINANCIAL CONDITION OR OPERATING RESULTS COULD BE
ADVERSELY AFFECTED.
COMPANY RISKS
THE SUCCESS OF OUR BUSINESS DEPENDS ON THE CONTINUED USE BY MAJOR MOVIE STUDIOS
OF OUR VIDEO COPY PROTECTION TECHNOLOGY.
If major motion picture studios were to determine that the benefits of
our technology do not justify the cost of licensing the technology, then demand
for our technology and our revenues would decline. We currently derive a
majority of our net revenues and operating income from fees for the application
of our patented video copy protection technology to various video formats:
prerecorded videocassettes, DVDs and digital pay per view or video on demand
(PPV/VOD) programs. These fees represented 63.1%, 63.0%, and 60.9% of our net
revenues during 2002, 2001 and 2000, respectively.
Any future growth in revenues from these fees will depend on (a) growth
in the various media formats, (b) increased use of our video copy protection
technology on a larger number of videocassettes, DVDs or digital PPV programs,
or (c) increases in usage fees or royalties. To increase or maintain our market
penetration, we must continue to persuade content owners that the cost of
licensing the technology is outweighed by the increase in revenues that content
owners and retailers gain as a result of using copy protection, such as revenues
from additional sales of the copy protected material or subsequent revenues from
other distribution channels.
The retail prices of DVDs are falling. As retail prices drop, studios
face increased pressure to trim operating expenses, which may include cutting
back in their copy protection usage, as well as negotiated reductions in their
usage fees. In the past we have seen our usage fees decline over time. Even
though we have contracts with minimum annual volume commitments, it is possible
for some studios to copy protect a smaller percentage of their titles and still
achieve their minimum volume commitments. In addition, some studios may
reconsider whether they want to continue to copy protect their older catalog
titles.
Any decline in demand for our video copy protection technology,
including a change of video copy protection policy by the major motion picture
studios, or a decline in sales of prerecorded videocassettes and DVDs that are
encoded with our video copy protection technology, or a material decline in our
average unit royalties, would have a material adverse effect on our business. If
several of the motion picture studios withdraw their support for our copy
protection technologies or otherwise determine not to copy protect a significant
portion of prerecorded videocassettes, DVD or digital PPV programs, our business
would be harmed.
OUR OPERATING RESULTS MAY FLUCTUATE, WHICH MAY ADVERSELY AFFECT THE PRICE OF OUR
COMMON STOCK.
Our quarterly and annual revenues, expenses and operating results could
vary significantly in the future and period-to-period comparisons should not be
relied upon as indications of future performance. Due to limited visibility in
predicting software licensing revenues and, particularly, revenues that are
generated from perpetual licenses (under which license fee revenue is recognized
upfront on a one-time basis) we may experience volatility in revenues which may
cause us to not be able to sustain our level of net revenues, or our rate of
revenue growth, on a quarterly or annual basis. In addition, we may be required
to delay or extend recognition of revenue on more complex licensing arrangements
as required under generally accepted accounting principles. Fluctuations in our
operating results may cause the price of our common stock to decline.
Further, we may not be in a position to anticipate a decline in revenues
in any quarter until late in the quarter. This is primarily due to the delay
inherent in reporting from certain licensees and closing of new sales
agreements, resulting in potential volatility in the price of our common stock.
Factors that could cause the price of our common stock to decline include:
o The timing of releases of popular movies on videocassettes, DVDs or by
digital PPV transmission;
o The ability of the Motion Picture Association of America studios to produce
one or more "blockbuster" titles on an annual basis;
o The degree of acceptance of our copy protection technologies by major motion
picture studios and software companies;
18
o The acceptance of our electronic licensing and DRM software by software
vendors and end-user organizations;
o The acceptance of our new music copy protection technologies by major music
labels in the U.S. market, Europe and Asia, and consumer reactions;
o The timing of releases of computer software CD-ROM multimedia titles;
o The extent to which various hacking technologies are viewed by our
customers to undermine our technologies; and
o The extent to which we are able to transition our market leading position
in optical media (i.e., packaged media) copy protection and our experience
in DRM to digital content distribution via the Internet.
The technology sector has experienced significant economic downturns,
exacerbated in part by a slowdown in U.S and foreign economies and by the
September 11, 2001 terrorist attacks in the U.S. As a consequence, our future
license fee revenue may experience fluctuations. Further softening in the
technology industry could affect our future results of operations, and may
affect the timing of orders from major customers.
WE EXPERIENCE SEASONALITY IN OUR OPERATING RESULTS, WHICH MAY AFFECT THE PRICE
OF OUR COMMON STOCK.
We have experienced significant seasonality in our business, and our
business is likely to be affected by seasonality in the future. We have
typically experienced our highest revenues in the fourth quarter of each
calendar year followed by lower revenues and operating income in the first
quarter, and at times in subsequent quarters, of the next year. We believe that
this trend has been principally due to the tendency of our customers to release
their more popular movies on videocassettes and DVDs during the year-end holiday
shopping season. We anticipate that revenues from consumer software copy
protection and DRM technologies and from music copy protection will reflect this
seasonal trend as well. Our revenues generally have tended to be lower in the
summer months, particularly in Europe.
WE DEPEND ON A SMALL NUMBER OF KEY CUSTOMERS FOR A HIGH PERCENTAGE OF OUR
REVENUES AND THE LOSS OF A SIGNIFICANT CUSTOMER COULD RESULT IN A SUBSTANTIAL
DECLINE IN OUR REVENUES AND PROFITS.
Our customer base and a majority of our net revenues is highly
concentrated, and is becoming increasingly concentrated, among a limited number
of customers, primarily due to the fact that the Motion Picture Association of
America studios dominate the motion picture industry and the loss of any one
customer would have a significant adverse impact on our business. Historically,
we have derived the majority of our net revenues from a relatively small number
of customers. Only one customer accounted for 11.4% of our net revenues in 2002,
no single customer accounted for more than 10% of our net revenues in 2001, and
one customer accounted for 10.3% of our net revenues in 2000, the Motion Picture
Association of America studios as a group accounted for 42.2%, 33.2% and 24.8%
of our net revenues in 2002, 2001 and 2000, respectively.
We expect that revenues from the Motion Picture Association of America
studios will continue to account for a substantial portion of our net revenues
for the foreseeable future. We have agreements with major home video companies
for copy protection of a substantial part of their videocassettes and/or DVDs in
the U.S. These agreements expire at various times ranging from 2003 to 2005. The
failure of any one of these customers to renew its contract or to enter into a
new contract with us on terms that are favorable to us would likely result in a
substantial decline in our net revenues and operating income, and our business
would be harmed.
Our major customers may have a large influence on industry standards and
the widespread adoption of new technologies. The selection of alternative
technologies to ours could harm our business.
WE DEPEND ON SIGNING HIGH-VALUE LICENSE AGREEMENTS DURING THE REPORTING PERIOD
FROM MAJOR SOFTWARE CUSTOMERS FOR OUR FLEXLM ELECTRONIC LICENSE MANAGEMENT
PRODUCTS AND THE INABILITY TO SIGN THESE AGREEMENTS COULD RESULT IN A DECLINE
IN OUR REVENUES AND PROFITS.
Currently, a material portion of our FLEXlm Electronic License
Management revenues are generated from perpetual licenses, under which license
fee revenue is generally recognized up front on a one-time basis. Failure to
close a small number of high-value perpetual licenses during any period could
result in a decline in our revenues and profits. We currently offer our
customers the choice between a perpetual license and an annual (or time based)
license, the latter of which results in ratable recognition of the license fee
over the term of the license, which is generally 12 months. We expect
19
that as we pursue more ISV customers in the mainstream enterprise software
market that we may engage in more custom software development projects that may
extend our revenue recognition by linking it to completion of this customized
software and formalized customer acceptance.
WE ARE DEPENDENT ON INTERNATIONAL SALES FOR A SUBSTANTIAL AMOUNT OF OUR REVENUE.
WE FACE DIVERSE RISKS IN OUR INTERNATIONAL BUSINESS, WHICH COULD ADVERSELY
AFFECT OUR OPERATING RESULTS.
International and export sales together represented 34.2%, 45.2%, and
42.3% of our video technology net revenues in 2002, 2001, and 2000,
respectively. We expect that international and export sales will continue to
represent a substantial portion of our net revenues for the foreseeable future.
Our future growth will depend to a large extent on worldwide acceptance and
deployment of our copy protection and DRM solutions for music CDs, digital PPV
networks, DVDs, and consumer software. Worldwide adoption of our FLEXlm ELM
technology will also be an important driver of future growth.
To the extent that foreign governments impose restrictions on
importation of programming, technology or components from the U.S., the
requirement for copy protection and rights management solutions in these markets
could diminish. In addition, the laws of some foreign countries may not protect
our intellectual property rights to the same extent as do the laws of the U.S.,
which increases the risk of unauthorized use of our technologies and the ready
availability or use of circumvention technologies. Such laws also may not be
conducive to copyright protection of digital content and software, which may
make our copy protection technology less effective and reduce the demand for it.
Due to our reliance on international and export sales, we are subject to
the risks of conducting business internationally, including:
o foreign government regulation;
o changes in diplomatic and trade relationships;
o changes in, or imposition of, regulatory requirements;
o changes in, or weakening of copyright and intellectual property (patent)
laws and support for copy protection and DRM technologies;
o tariffs or taxes and other trade barriers and restrictions;
o fluctuations in our net effective income tax rate driven by changes in the
percentage of revenues that we derive from international sources;
o difficulty in staffing and managing foreign operations; and
o fluctuations in foreign currency exchange rates.
Our business could be materially adversely affected if foreign markets
do not continue to develop, if we do not receive additional orders to supply our
technologies or products for use in foreign prerecorded video, music, PPV and
other applications requiring our copy protection solutions or if regulations
governing our international businesses change. For example, our products are
eligible for export under the U.S. Export Administration Act and U.S. export
regulations. The company has implemented a program to comply with these laws and
regulations, but cannot guarantee that any particular product can be exported to
any particular location at any particular time. Any changes to the statute or
the regulations with respect to export of encryption technologies could require
us to redesign our products or technologies or prevent us from selling our
products and licensing our technologies internationally.
20
POTENTIAL INTELLECTUAL PROPERTY CLAIMS AND LITIGATION COULD SUBJECT US TO
SIGNIFICANT LIABILITY FOR DAMAGES AND INVALIDATION OF OUR INTELLECTUAL
PROPERTY RIGHTS.
Litigation may be necessary in the future to enforce our patents and
other intellectual property rights, to protect our trade secrets or to determine
the validity and scope of the proprietary rights of others. We are currently
subject to several legal proceedings. See "Legal Proceedings."
Litigation could harm our business and result in:
o substantial settlement or related costs, including indemnification of
customers;
o diversion of management and technical resources;
o our discontinuing the use and sale of infringing products;
o our expending significant resources to develop non-infringing technology;
and
o our obtaining licenses to infringed technology.
OUR SUCCESS IS HEAVILY DEPENDENT UPON OUR PROPRIETARY TECHNOLOGIES.
We rely on a combination of patent, trademark, copyright and trade
secret laws, nondisclosure and other contractual provisions, and technical
measures to protect our intellectual property rights. Our patents, trademarks or
copyrights may be challenged and invalidated or circumvented. Our patents may
not be of sufficient scope or strength or be issued in all countries where our
products can be sold. The last of our core group of analog copy protection
patents expire in the year 2017. In many cases, we have filed applications to
expand our patent claims and for improvement patents to extend the current
expiration dates, however, expiration of some of our patents may harm our
business.
Others may develop technologies that are similar or superior to our
technologies, duplicate our technologies or design around our patents. A number
of companies with extensive financial resources have developed intellectual
property in the digital rights management field, including Intertrust, Philips,
Sony, ContentGuard and Microsoft. Such competitive threats could harm our
business.
Effective intellectual property protection may be unavailable or limited
in some foreign countries. Despite efforts to protect our proprietary rights,
unauthorized parties may attempt to copy or otherwise use aspects of processes
and devices that we regard as proprietary. Policing unauthorized use of our
proprietary information is difficult, and the steps we have taken may not
prevent misappropriation of our technologies.
IT MAY BE TIME-CONSUMING AND COSTLY TO ENFORCE OUR PATENTS AGAINST DEVICES AND
HACKING TECHNIQUES THAT ATTEMPT TO CIRCUMVENT OUR COPY PROTECTION TECHNOLOGY,
AND OUR FAILURE TO CONTROL THEM COULD HARM OUR BUSINESS.
We use our patents to limit the proliferation of devices intended to
circumvent our video copy protection technologies. In the past, we have
initiated a number of patent infringement disputes against manufacturers and
distributors of these devices and software. Any legal action that we may
initiate could be time-consuming to pursue, result in costly litigation, and
divert management's attention from day-to-day operations.
We have one lawsuit of this type pending in Germany to require the
defendant to discontinue the sale of devices that circumvent our video copy
protection technologies, as we believe the device infringes one or more of our
circumvention patents. In the event of an adverse ruling in this litigation or
in any similar litigation, the value of our video protection technology may
decline due to the legal availability of such a circumvention device, or we may
have to obtain rights to the offending devices to protect the value of our
technology. The legal availability of circumvention devices could result in the
increased proliferation of devices that defeat our copy protection technology
and a decline in demand for our technologies, which could have a material
adverse effect on our business in Germany.
A limited number of DVD manufacturers may build products that either do
not contain our copy protection technology, or include features that allow
consumers to bypass copy protection. Although we believe this is in
contravention of the U.S. Digital Millennium Copyright Act, as well as the basic
DVD CSS license, proliferation of these products could cause a decline in demand
for our technologies, which could harm our business. Any legal or other
21
enforcement action that we may initiate could be time consuming to pursue,
result in costly litigation, and divert management's attention from day-to-day
activities.
In the electronic license management market, our products include
patented technologies. Any legal action that we may initiate regarding these
patents may be time-consuming to pursue, involve costly litigation, divert
management's attention from operations or may not be successful. See "Legal
Proceedings."
In the consumer software copy protection segment, a number of
individuals have developed and posted SafeDisc hacks on the Internet, or CD
cloning software. If we are not able to develop frequent SafeDisc software
releases and new digital signatures, which deter the hackers from developing
circumvention or cloning techniques, our customers could reduce their usage of
our technology because it was compromised. We expect to encounter similar
challenges in the music copy protection business. Although the
anti-circumvention provisions in the U.S. Digital Millennium Copyright Act may
be applicable to Internet service providers who support the hacker sites, any
legal action that we initiate could be time-consuming to pursue, result in
costly litigation, and divert management's attention from day-to-day operations.
LEGISLATIVE INITIATIVES SEEKING TO WEAKEN COPYRIGHT LAW COULD HARM OUR BUSINESS.
Consumer rights advocates and other constituencies are challenging
copyright law, notably the U.S. Digital Millennium Copyright Act, through both
legislative and judicial actions. If copyright law is compromised, or devices
that can circumvent our technology are permitted by law and become prevalent,
this could result in reduced demand for our video copy protection technologies
in particular, and our business would be harmed.
WE ARE EXPOSED TO RISKS ASSOCIATED WITH EXPANDING OUR TECHNOLOGY BASE THROUGH
STRATEGIC ACQUISITIONS AND INVESTMENTS.
We have expanded our technology base in the past through strategic
acquisitions and investments in companies with complementary technologies or
intellectual property and intend to do so in the future. Acquisitions always
hold special challenges in terms of successful integration of technologies,
products and employees. For companies we have acquired in the past and companies
we acquire in the future, we may not be able to incorporate any acquired
services, products or technologies with our existing operations, or integrate
personnel from the acquired businesses, in which case our business could be
harmed.
The negotiation, creation and management of the strategic relationships
typically involve a substantial commitment of our management time and resources.
We have in the past and may in the future be required to write off all or part
of one or more of these investments that could harm our business.
Our strategic investments typically involve joint development, joint
marketing, or entry into new business ventures, or new technology licensing. Any
joint development efforts may not result in the successful introduction of any
new products by us or a third party, and any joint marketing efforts may not
result in increased demand for our products. Further, any current or future
strategic acquisitions and investments by us may not allow us to enter and
compete effectively in new markets or enhance our business in any current
markets.
We currently hold minority equity interests in a number of companies,
including Digimarc, TTR, Command Audio, Digital Fountain, iVAST, NTRU
Cryptosystems, and Widevine Technologies. These investments, totaling $28.7
million, represented 8.9% of our total assets as of December 31, 2002. Command
Audio, Digital Fountain, iVAST, NTRU Cryptosystems, and Widevine Technologies
are privately held companies. There is no active trading market for the
securities of these privately held companies and our investments in them are
illiquid. We may never have an opportunity to realize a return on our investment
in these private companies, and we may in the future be required to write off
all or part of one or more of these investments. During 2002 and 2001, we wrote
off $17.2 million and $6.9 million, respectively, of strategic investments
resulting from impairment that was other-than-temporary. There were no
comparable write-offs in 2000.
INVESTMENT IN NEW TECHNOLOGIES, MARKET DEVELOPMENT AND ADMINISTRATIVE
INFRASTRUCTURE COULD RESULT IN LOWER MARGINS.
We intend to continue to pursue our intellectual property-based
licensing model, which has historically been characterized by high margins and
recurring revenues. Our operating margins, though very high in relative terms,
have fallen over the last four quarters, and it is possible we could see margins
erode further as we continue to invest in new
22
technologies, market areas or administrative infrastructure. While we look for
acquisition transactions that will expand our copy protection and rights
management capabilities, acquisition activities could also cause operating
margins to fall depending on the acquiree's operating model.
WE MUST CONTINUE TO PROVIDE SATISFACTORY SUPPORT AND MAINTENANCE SERVICES TO OUR
ELM CUSTOMERS.
Our future success will depend on our ability to provide adequate
software support and maintenance services to our independent software vendor ELM
customers. As they release new applications or modify their software to run on
new platforms, it is important that their businesses not be disrupted as a
result of inadequate support from us. Failure to deliver such services could
harm our business.
WE DEPEND ON THIRD PARTIES TO IMPLEMENT AND SUPPORT SAFEDISC AND SOME OF OUR
MUSIC COPY PROTECTION SOFTWARE MODULES WITHIN THEIR ENCODING AND QUALITY
ASSURANCE EQUIPMENT.
We rely on third party vendors such as DCA, Eclipse, Media Morphics and
CD Associates to develop and incorporate software modules that will:
o apply the SafeDisc digital signature and audio copy protection and
authentication generator at licensed replication facilities; and
o allow replicators to run specialized quality assurance tests to confirm the
SafeDisc or audio protection technologies are applied.
Our operations could be disrupted if our relationships with third party
vendors are disrupted or if their products are defective, not available or not
accepted by licensed replicators. This could result in a loss of customer orders
and revenue.
The SafeDisc CD copy protection technology is available to approximately
120 of the world's largest mastering and replication facilities worldwide, and
is designed to be fully compatible with standard CD manufacturing processes.
Nevertheless, we rely on such third parties to properly apply the SafeDisc CD
copy protection technology to content on behalf of our customers and to properly
perform quality assurance testing with respect to such content. Any improper
application of the technology or improper quality assurance testing by such
third party mastering and replication facilities may result in content that does
not contain our copy protection technology or may result in other defects in the
rights holders content, and may therefore, result in a loss of revenue or a
claim against us by the content owner.
WE MUST ESTABLISH AND MAINTAIN LICENSING RELATIONSHIPS WITH COMPANIES OTHER THAN
CONTENT OWNERS OR SOFTWARE PUBLISHERS TO CONTINUE TO BUILD AND SUPPORT A
WORLDWIDE COPY PROTECTION ECOSYSTEM AND TO EXPAND OUR BUSINESS, AND FAILURE
TO DO SO COULD HARM OUR BUSINESS PROSPECTS.
Our future success will depend upon our ability to establish and
maintain licensing relationships with companies in related business fields,
including:
o DVD and CD authoring facilities, mastering houses and replicators;
o DVD and CD authoring tools software companies;
o DVD and CD hardware manufacturers;
o videocassette duplicators;
o international distributors of videocassettes;
o semiconductor and equipment manufacturers;
o operators of digital PPV networks;
o consumer electronics and digital PPV set-top hardware manufacturers; and
o DRM suppliers, especially in the music business.
23
Substantially all of our license agreements are non-exclusive, and
therefore our licensees are free to enter into similar agreements with third
parties, including our competitors. Our licensees may develop or pursue
alternative technologies either on their own or in collaboration with others,
including our competitors.
Some of our third party license arrangements will require that we
license others' technologies and or integrate our solutions with others. As an
example, our customers will expect that our music copy protection,
authentication, and controlled burning technologies will be integrated with
various DRM solutions. If these third parties choose not to support integration
efforts or delay the integration, our business could be harmed.
OUR PRODUCTS COULD HAVE DEFECTS.
We offer and develop a series of complex copy protection and digital
rights management products, which we license to customers. Due to the complexity
of these products offered and developed, the products may contain undetected
defects or errors that may affect the proper use or application of such products
by the customer. Despite our quality assurance testing, defects or errors may
occur in existing or new products, which could result in loss of revenue or
market share, failure to achieve market acceptance, diversion of development
resources, injury to our reputation, increased insurance costs and increased
service, any of which could materially harm our business. The performance of
these products typically involves working with sophisticated software, computing
and communications systems. Our inability to meet customer expectations in a
timely manner could also result in a loss of, or delay in, revenue, loss of
market share, failure to achieve market acceptance, injury to our reputation and
increased costs.
In addition, we rely on the customer and third party replicators to
properly use our products to protect the software and applications to which the
process may be applied. Any improper use or application of the software by the
customer or the third party replicators may render the process useless and
result in losses from claims arising out of such improper use of the products.
Because customers rely on our products for copy protection and digital
rights management of their software and applications, defects or errors in our
products may discourage customers from purchasing our products. These defects or
errors could also result in product liability or warranty claims. Although we
attempt to reduce the risk of losses resulting from these claims through
warranty disclaimers and limitation of liability clauses in our agreements,
these contractual provisions may not be enforceable in every instance.
Furthermore, although we maintain errors and omissions insurance, this insurance
may not adequately cover these claims. If a court refused to enforce the
liability-limiting provisions of our contracts for any reason, or if liabilities
arose that were not contractually limited or adequately covered by insurance,
our business could be materially harmed.
In protecting copyrights and other intellectual property rights of our
customers, our products affect consumer use of our customers' products.
Consumers may view this negatively and discontinue or threaten to discontinue
use of our customers' products unless our customers stop using our technologies.
This may cause a decline in demand for our products or legal actions against us
by our customers or consumers. Third-party consumers are not likely to be
subject to the liability-limiting provisions that are contained in our contracts
with our customers.
IF USE OF THE INTERNET FOR DELIVERY OF SOFTWARE DOES NOT INCREASE AS WE
ANTICIPATE, OUR BUSINESS WILL SUFFER.
Some of our products, such as SafeCast and MacroSafe, are designed to
support using the Internet to deliver, deploy, activate or pay for software or
digital media. The revenues we generate from these products depend on increased
acceptance and use of the Internet as a medium of commerce, communications and
delivery of software and digital media. Acceptance and use of the Internet may
not continue to develop at historical rates, and a sufficiently broad base of
business customers may not adopt or continue to use the Internet to conduct
their operations. Demand and market acceptance for recently introduced services
and products over the Internet are subject to a high level of uncertainty, and
there are few proven services and products. Our business could be seriously
harmed if:
o The necessary communication and computer network technology underlying the
Internet and other online service does not effectively support any
expansion that may occur;
o New standards and protocols are not developed or adopted in a timely
manner; or
24
o Concerns about security, reliability, cost, ease of use, accessibility,
quality of service, or other factors results in the Internet not becoming
established as a viable commercial marketplace, inhibiting the development
of electronic commerce and reducing the need for and desirability of our
products and services.
IF USE OF THE INTERNET FOR DELIVERY OF VIDEO AND AUDIO PROGRAMMING INCREASES,
OUR BUSINESS MAY SUFFER.
Some of our products, such as video, audio and packaged software copy
protection, are designed to be applied to packaged media, and we receive
royalties based on the number of units produced. If delivery of such products
using the Internet were to increase, our revenues from packaged media may be
adversely affected and not replaced by Internet-based revenues. In this event,
our business could be seriously harmed.
IF WE DO NOT RETAIN OUR KEY EMPLOYEES AND ATTRACT NEW EMPLOYEES, OUR ABILITY TO
EXECUTE OUR BUSINESS STRATEGY WILL BE IMPAIRED.
We compete for employees in California's Silicon Valley. Hiring and
retaining key personnel is highly competitive. Because of the specialized nature
of our business, our future success will depend upon our continuing ability to
identify, attract, train and retain other highly skilled managerial, technical,
sales and marketing personnel, particularly as we enter new markets. In
particular, our current stock option plan may be deemed less effective in
retaining employees due to the overall decline in technology market values and
the resultant impact on our stock price. We currently have a high percentage of
our employees and executives who have underwater stock options, and we have a
shortage of new options available to satisfy the long-range incentive
expectations of many of our key employees. In the upcoming Proxy for our annual
meeting, we will be submitting proposals to expand the employee option pool and
to implement an employee option tender to replace in 6 months plus 1 day certain
underwater options with smaller numbers of new options. We believe that a
failure by shareholders to support these proposals may lead to the loss of key
executives and employees that could harm our business.
CALAMITIES OR TERRORIST ATTACKS IN SILICON VALLEY, AS WELL AS THE U.K. OR OTHER
COUNTRIES IN WHICH OUR OFFICES ARE LOCATED COULD DISRUPT OUR BUSINESS AND
ADVERSELY AFFECT OUR OPERATIONS.
Our headquarters office facilities in Santa Clara, California are in
areas of seismic activity near active earthquake faults. Any earthquake, fire or
other calamity affecting our facilities may disrupt our business and
substantially affect our operations. A terrorist attack targeting Silicon
Valley, as well as the U.K. or other countries in which our offices are located
could disrupt our business and substantially affect our operations.
INDUSTRY RISKS
IF CONSUMER REACTION TO MUSIC COPY PROTECTION AND DIGITAL RIGHTS MANAGEMENT
TECHNOLOGIES IS UNFAVORABLE, OUR REVENUE POTENTIAL WILL BE ADVERSELY
AFFECTED.
It is possible that there could be significant consumer resistance to
audio copy protection, as consumers may feel that copy protection degrades the
sound quality of the original or that they are entitled to copy audio CDs,
because no technology has been used in the past to prevent copying. It is not
clear whether the major music labels will deploy any copy protection solutions
if there is sustained consumer resistance. To date, we have seen limited
acceptance of our technology in Europe and Japan. The music labels have not
moved to deploy the technology in the U.S. because they completely do not
believe they have adequately tested the second session solution, nor are they
completely satisfied with effectiveness and playability levels of the first
session (Redbook) solution. If the music labels conclude that shipping
increasingly meaningful volumes of CDs that include our technologies generate
unacceptable consumer backlash, our revenue potential will be adversely
affected.
There may be consumer resistance to the adoption of DRM technology in
consumer software. There has been significant media attention in recent months
regarding the implementation of SafeCast by one of our customers, a major
consumer software vendor. This customer is now the defendant in a consumer class
action lawsuit arising from its use of our SafeCast technology. Consumer
resistance to this technology, further negative media coverage and legal actions
against our customers and us may slow broad adoption of this technology and harm
our business.
WE LICENSE TECHNOLOGY FOR DIGITAL VOD AND PPV COPY PROTECTION, AND IF THIS
MARKET DOES NOT GROW AS ANTICIPATED OR WE ARE UNABLE TO SERVE THIS MARKET
EFFECTIVELY, OUR REVENUES WILL BE ADVERSELY AFFECTED.
25
While our copy protection capability is embedded in more than 100
million digital set-top boxes manufactured by the leading digital set-top box
manufacturers, only nine system operators have activated copy protection for
digital PPV programming. Our ability to expand our markets in additional home
entertainment venues such as digital PPV or video on demand ("VOD") will depend
in large part on the support of the major motion picture studios in advocating
the incorporation and activation of copy protection technology in the hardware
and network infrastructure required to distribute such video programming. If the
Motion Picture Association of America studios do not require copy protection
activation for any of their PPV or VOD movies, or if PPV/VOD system operators do
not specify our copy protection in their set-top boxes, or if the system
operators do not activate copy protection in other digital PPV networks outside
of Japan, Hong Kong or the United Kingdom, then our business will be harmed.
Further, consumers may react negatively to copy protected PPV or VOD
programming because they may feel they have an entitlement having in the past
routinely copied for later viewing analog cable and satellite-delivered
subscription television and PPV programs, as well as free broadcast programming.
In addition, when incoming video signals are routed through a VCR before
reaching a TV set, the consumer may see impaired pictures while viewing a copy
protected digital PPV program. If there is consumer dissatisfaction that cannot
be managed, or if there are technical compatibility problems, our business would
be harmed.
POTENTIAL REVENUE MAY BE LOST IF THE VWM COMPANIES' DIGITAL VIDEO WATERMARKING
TECHNOLOGY IS NOT SELECTED AS AN INDUSTRY STANDARD OR OTHERWISE ACHIEVE BROAD
MARKET ACCEPTANCE.
In cooperation with Digimarc Corporation, Hitachi Ltd., Koninklijke
Philips N.V., NEC Corporation, Pioneer Corporation and Sony Corporation, we have
developed a digital video watermarking solution to address the
digital-to-digital copying issues associated with the next generation of DVD
recording devices. Our group (the "VWM Companies") has submitted a proposed
solution to the DVD Copy Control Association, or DVD CCA, which has assumed
responsibility for selecting the industry standard. Macrovision has been
selected as the exclusive licensing agent for the VWM Companies' watermarking
solution. Our group is competing with Toshiba Corporation, which has also
submitted a proposal to the DVD CCA.
While there is no