UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended December 31, 2002
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number 0-24363
Interplay Entertainment Corp.
(Exact name of the registrant as specified in its charter)
Delaware 33-0102707
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
16815 Von Karman Avenue, Irvine, California 92606
(Address of principal executive offices)
(949) 553-6655 (Registrant's telephone number, including area code)
Securities registered pursuant of Section 12 (b) of the Act: None
Securities registered pursuant of Section 12 (g) of the Act:
Common Stock, $0.001 par value
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]
As of June 28, 2002, the aggregate market value of voting common stock held by
non-affiliates was $3,056,628, based upon the closing price of the Common Stock
on that date.
As of March 21, 2003, 93,849,176 shares of Common Stock of the Registrant were
issued and outstanding.
Documents Incorporated by Reference
Portions of the definitive proxy statement for the issuer's 2003 Annual Meeting
of Stockholders are incorporated by reference into Part III of this Report.
INTERPLAY ENTERTAINMENT CORP.
INDEX TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2002
PAGE
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PART I
Item 1. Business 4
Item 2. Properties 11
Item 3. Legal Proceedings 11
Item 4. Submission of Matters to a Vote of Security Holders 12
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 13
Item 6. Selected Financial Data 15
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations 16
Item 7A. Quantitative and Qualitative Disclosure about
Market Risk 38
Item 8. Consolidated Financial Statements and Supplementary
Data 39
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 39
PART III
Item 10. Directors and Executive Officers of the Registrant 39
Item 11. Executive Compensation 39
Item 12. Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters 39
Item 13. Certain Relationships and Related Transactions 39
Item 14. Controls and Procedures 39
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports
on Form 8-K 40
Signatures 41
Exhibit Index 43
2
This Form 10-K contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities and Exchange Act of 1934 and such forward-looking statements are
subject to the safe harbors created thereby. For this purpose, any statements
contained in this Form 10-K except for historical information may be deemed to
be forward-looking statements. Without limiting the generality of the foregoing,
words such as "may," "will," "expect," "believe," "anticipate," "intend,"
"could," "estimate" or "continue" or the negative or other variations thereof or
comparable terminology are intended to identify forward-looking statements. In
addition, any statements that refer to expectations, projections or other
characterizations of future events or circumstances are forward-looking
statements.
The forward-looking statements included in this Form 10-K are based on
current expectations that involve a number of risks and uncertainties, as well
as certain assumptions. For example, any statements regarding future cash flow,
financing activities, cost reduction measures, replacement of the Company's
terminated line of credit are forward-looking statements and there can be no
assurance that the Company will generate positive cash flow in the future or
that the Company will be able to obtain financing on satisfactory terms, if at
all, or that any cost reductions effected by the Company will be sufficient to
offset any negative cash flow from operations; or that the Company will be able
to renew or replace its line of credit. Additional risks and uncertainties
include possible delays in the completion of products, the possible lack of
consumer appeal and acceptance of products released by the Company, fluctuations
in demand, lost sales because of the rescheduling of product launches or order
deliveries, failure of the Company's markets to continue to grow, that the
Company's products will remain accepted within their respective markets, that
competitive conditions within the Company's markets will not change materially
or adversely, that the Company will retain key development and management
personnel, that the Company's forecasts will accurately anticipate market demand
and that there will be no material adverse changes in the Company's operations
or business. Additional factors that may affect future operating results are
discussed in more detail in "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future Performance".
Assumptions relating to the foregoing involve judgments with respect to, among
other things, future economic, competitive and market conditions, and future
business decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond the control of the Company. Although the
Company believes that the assumptions underlying the forward-looking statements
are reasonable, the business and operations of the Company are subject to
substantial risks that increase the uncertainty inherent in the forward-looking
statements, and the inclusion of such information should not be regarded as a
representation by the Company or any other person that the objectives or plans
of the Company will be achieved. In addition, risks, uncertainties and
assumptions change as events or circumstances change. The Company disclaims any
obligation to publicly release the results of any revisions to these
forward-looking statements which may be made to reflect events or circumstances
occurring subsequent to the filing of this Form 10-K with the SEC or otherwise
to revise or update any oral or written forward-looking statement that may be
made from time to time by or on behalf of the Company.
Interplay (R), Interplay Productions(R) and certain of the Company's
product names and publishing labels referred to in this Form 10-K are the
Company's trademarks. This Annual Report on Form 10-K also contains trademarks
belonging to others.
3
PART I
Item 1. BUSINESS
OVERVIEW AND RECENT DEVELOPMENTS
Interplay Entertainment Corp., which we refer to in this Form 10-K as "we,"
"us," or "our," is a developer and publisher of interactive entertainment
software for both core gamers and the mass market. We were incorporated in the
State of California in 1982 and were reincorporated in the State of Delaware in
May 1998. We are most widely known for our titles in the action/arcade,
adventure/role playing game (RPG), and strategy/puzzle categories. We have
produced titles for many of the most popular interactive entertainment software
platforms, and currently balance our publishing and distribution business by
developing interactive entertainment software for PCs and next generation video
game consoles, such as the Sony PlayStation 2, Microsoft Xbox and Nintendo
GameCube.
We seek to publish interactive entertainment software titles that are, or
have the potential to become, franchise software titles that can be leveraged
across several releases and/or platforms, and have published many such
successful franchise titles to date. In addition, we hold licenses to use
popular brands, such as Advanced Dungeons and Dragons, for incorporation into
certain of our products.
During 2002 we continued to experience cash flow difficulties from
operations, and relied upon sales of assets to pay liabilities, reduce future
operational costs and fund our ongoing operations. We have been operating
without a credit facility since October 2001, which has adversely affected cash
flow. We expect these difficulties to continue during 2003.
In February 2003 Virgin Interactive Entertainment (Europe) Limited, the
operating subsidiary of Virgin Interactive Entertainment Limited ("Virgin"), our
European distributor, filed for a Company Voluntary Arrangement or "CVA", a
process of reorganization in the United Kingdom, which must be approved by
Virgin's creditors. Virgin owed us approximately $1.8 million at December 31,
2002. As of March 28, 2003, the CVA was rejected by Virgin's creditors, and
Virgin is presently negotiating with its creditors to propose a new CVA. We do
not know what affect approval of the CVA will have on our ability to collect
amounts Virgin owes us. If the new CVA is not approved, we expect Virgin to
cease operations and liquidate, in which event we will most likely not receive
any amounts presently due us by Virgin, and will not have a distributor for our
products in Europe and the other territories in which Virgin presently
distributes our products.
In February 2003, we amended our license agreement with Infogrames, the
holder of the TSR license which we rely on to publish the Baldur's Gate,
Baldur's Gate: Dark Alliance, and Icewind Dale titles, to, among other things,
(i) extend the license term for approximately an additional two years to
December 31, 2008 (provided we make a timely extension payment required for such
extension), and (ii) extend our rights with respect to certain of the Advanced
Dungeons & Dragons properties. The amendment further terminates our rights to
certain titles in the event Interplay is unable to obtain certain third-party
waivers in accordance with the terms of the amendment. We were unable to obtain
the required waivers within the permitted time period and as a result have lost
rights to publish Baldur's Gate 3 and its sequels on the PC, a significant
product franchise. We are in negotiations with Infogrames to reinstate these
rights, but no assurance can be given that we will be successful.
In January 2002, we settled a dispute with a developer related to the sale
of publishing rights for one of our products and the recognition of deferred
revenue for a licensing transaction. We sold the publishing rights to this title
to the distributor in connection with a settlement agreement entered into with
the third party developer. The settlement agreement provided, among other
things, that we assign our rights and obligations under the product agreement to
the third party distributor. As a result, we recorded net revenues of $5.6
million in the three months ended March 31, 2002.
In April 2002, we sold our product development subsidiary, Shiny
Entertainment, Inc. for $47.2 million which was paid as follows: we received
$13.8 million in cash payments, $26.1 million was paid directly to third party
creditors, and $7.3 million was paid to Shiny's president and Shiny Group, his
wholly-owned subsidiary, for Shiny common stock that was issued to them to
settle claims relating to our original acquisition of Shiny. We recognized a
gain of $28.8 million on the sale of Shiny.
4
In August 2002, we entered into a new distribution arrangement with Vivendi
Universal Games, Inc. (the parent company of Universal Studios, Inc., who as of
today owns approximately 5 percent of our common stock), or "Vivendi," whereby,
Vivendi will distribute substantially all of our products in North America for a
period of three years as a whole and two years with respect to each product
giving a potential maximum term of five years. Under the August 2002 agreement,
Vivendi will pay us sales proceeds less amounts for distribution fees, price
concessions and returns. Vivendi is responsible for all manufacturing, marketing
and distribution expenditures, and bears all credit, price concessions and
inventory risk, including product returns. Upon our delivery of a gold master to
Vivendi, Vivendi will pay us, as a non-refundable minimum guarantee, a specified
percent of the projected amount due to us based on projected initial shipment
sales, which are established by Vivendi in accordance with the terms of the
agreement. The remaining amounts are due upon shipment of the titles to
Vivendi's customers. Payments for future sales that exceed the projected initial
shipment sales are paid on a monthly basis.
PRODUCTS
We develop and publish interactive entertainment software titles that
provide immersive game experiences by combining advanced technology with
engaging content, vivid graphics and rich sound. We utilize the experience and
judgment of the avid gamers in our product development group to select and
produce the products we publish. Our strategy is to invest in products for those
platforms, whether PC or video game console, that have or will have sufficient
installed bases for the investment to be economically viable. We currently
develop and publish products for the PC platform compatible with Microsoft
Windows, and for video game consoles such as the Sony PlayStation 2, the
Microsoft Xbox and the Nintendo GameCube. In addition, we anticipate substantial
growth in the use of high-speed Internet access, which could possibly provide
significantly expanded technical capabilities for the PC platform.
We assess the potential acceptance and success of emerging platforms and
the anticipated continued viability of existing platforms based on many factors,
including the number of competing titles, the ratio of software sales to
hardware sales with respect to the platform, the platform's installed base,
changes in the rate of the platform's sales and the cost and timing of
development for the platform. We must continually anticipate and assess the
emergence of, and market acceptance of, new interactive entertainment hardware
platforms well in advance of the time the platform is introduced to consumers.
Because product development cycles are difficult to predict, we are required to
make substantial product development and other investments in a particular
platform well in advance of the platform's introduction. If a platform for which
we develop software is not released on a timely basis or does not attain
significant market penetration, our business, operating results and financial
condition could be materially adversely affected. Alternatively, if we fail to
develop products for a platform that does achieve significant market
penetration, then our business, operating results and financial condition could
also be materially adversely affected.
We have entered into license agreements with Sega, Sony Computer
Entertainment, Microsoft Corporation and Nintendo pursuant to which the Company
has the right to develop, sublicense, publish, and distribute products for the
licensor's respective platforms in specified territories. In certain cases, the
products are manufactured for us by the licensor. We pay the licensor a royalty
or manufacturing fee in exchange for such license and manufacturing services.
Such agreements grant the licensor certain approval rights over the products
developed for their platform, including packaging and marketing materials for
such products. There can be no assurance that we will be able to obtain future
licenses from platform companies on acceptable terms or that any existing or
future licenses will be renewed by the licensors. Our inability to obtain such
licenses or approvals could have a material adverse effect on our business,
operating results and financial condition. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Factors Affecting
Future Performance-- We may fail to maintain existing licenses, or obtain new
licenses from hardware companies on acceptable terms or to obtain renewals of
existing or future licenses from licensors."
The interactive entertainment software industry is highly seasonal, with
the highest levels of consumer demand occurring during the year-end holiday
buying season. As a result, our net revenues, gross profits and operating income
have historically been highest during the second half of the year. The impact of
this seasonality will increase as we rely more heavily on game console net
revenues in the future. Seasonal fluctuations in revenues from game console
products may cause material harm to our business and financial results.
5
PRODUCT DEVELOPMENT
We develop or acquire our products from a variety of sources, including our
internal development studios and publishing relationships with leading
independent developers.
The Development Process. We develop original products both internally,
using our in-house development staff, and externally, using third party software
developers working under contract with us. Producers on our internal staff
monitor the work of both inside and third party development teams through design
review, progress evaluation, milestone review and quality assurance. In
particular, each milestone submission is thoroughly evaluated by our product
development staff to ensure compliance with the product's design specifications
and our quality standards. We enter into consulting or development agreements
with third party developers, generally on a flat-fee, work-for-hire basis or on
a royalty basis, whereby we pay development fees or royalty advances based on
the achievement of milestones. In royalty arrangements, we ultimately pay
continuation royalties to developers once our advances have been recouped. In
addition, in certain cases, we will utilize third party developers to convert
products for use with new platforms.
Our products typically have short life cycles, and we therefore depend on
the timely introduction of successful new products, including enhancements of or
sequels to existing products and conversions of previously-released products to
additional platforms, to generate revenues to fund operations and to replace
declining revenues from existing products. The development cycle of new products
is difficult to predict, and involves a number of risks. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Factors Affecting Future Performance-- If we fail to anticipate
changes in video game platforms and technology, our business may be harmed."
During the years ended December 31, 2002, 2001 and 2000, we spent $16.2
million, $20.6 million and $22.2 million, respectively, on product research and
development activities. Those amounts represented 37 percent, 36 percent and 21
percent, respectively, of revenue in each of those periods.
INTERNAL PRODUCT DEVELOPMENT
U.S. Product Development. Our internal product development group in the
United States consisted of approximately 157 people at December 31, 2002. Once
we select a design for a product, we establish a production team, development
schedule and budget for the product. Our internal development process includes
initial design and concept layout, computer graphic design, 2D and 3D artwork,
programming, prototype testing, sound engineering and quality control. The
development process for an original, internally developed product typically
takes from 12 to 24 months, and six to 12 months for the porting of a product to
a different technology platform. We utilize a variety of advanced hardware and
software development tools, including animation, sound compression utilities and
video compression for the production and development of our interactive
entertainment software titles. Our internal development organization is divided
into separate studios, each dedicated to the production and development of
products for a particular product category. Within each studio, development
teams are assigned to a particular project. These teams are generally led by a
producer or associate producer and include game designers, software programmers,
artists, product managers and sound technicians. We believe that the separate
studios approach promotes the creative and entrepreneurial environment necessary
to develop innovative and successful titles. In addition, we believe that
breaking down the development function into separate studios enables us to
improve our software design capabilities, to better manage our internal and
external development processes and to create and enhance our software
development tools and techniques, thereby enabling us to obtain greater
efficiency and improved predictability in the software development process.
Shiny Entertainment. In April 2002, we sold our former subsidiary Shiny
Entertainment, Inc., which was developing a video game based on the motion
picture "The Matrix," to Infogrames Entertainment, Inc. for $47.2 million. After
recognizing closing costs, consideration to Warner Brothers for their consent to
transfer the Matrix license and expensing amounts previously paid for the Matrix
license, we recognized a gain of $28.8 million on this sale.
International Development. During 2001, we reassigned the process of
Interplay Productions Limited, our European subsidiary responsible for our
product development efforts in Europe to our corporate headquarters. Prior to
the reassignment, Interplay Productions Limited engaged and managed the efforts
of third party developers located in various European countries. We currently
have one original product under development in Europe, which we now manage from
our corporate headquarters in Irvine, California.
6
EXTERNAL PRODUCT DEVELOPMENT
To expand our product offerings to include hit titles created by third
party developers, and to leverage our publishing capabilities, we enter into
publishing arrangements with third party developers. In the years ended December
31, 2002, 2001 and 2000, approximately 67 percent, 80 percent and 70 percent,
respectively, of new products we released and which we believe are or will
become franchise titles were developed by third party developers. We expect that
the proportion of our new products which are developed externally may vary
significantly from period to period as different products are released. In
selecting external titles to publish, we seek titles that combine advanced
technologies with creative game design. Our publishing agreements usually
provide us with the exclusive right to distribute, or license another party to
distribute, a product on a worldwide basis (although, in certain instances our
rights are limited to a specified territory). We typically fund external
development through the payment of advances upon the completion of milestones,
which advances are credited against royalties based on sales of the products.
Further, our publishing arrangements typically provide us with ownership of the
trademarks relating to the product as well as exclusive rights to sequels to the
product. We manage the production of external development projects by appointing
a producer from one of our internal product development studios to oversee the
development process and work with the third party developer to design, develop
and test the game. At December 31, 2002, we had six titles being developed by
third party developers.
We believe this strategy of cultivating relationships with talented third
party developers provides an excellent source of quality products, and a number
of our commercially successful products have been developed under this strategy.
However, our reliance on third party software developers for the development of
a significant number of our interactive software entertainment products involves
a number of risks. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future Performance--Our
reliance on third party software developers subjects us to the risks that these
developers will not supply us with high quality products in a timely manner or
on acceptable terms."
SEGMENT INFORMATION
We operate primarily in one industry segment, the development, publishing
and distribution of interactive entertainment software. For information
regarding the revenues and assets associated with our geographic segments, see
Note 14 of the Notes to our Consolidated Financial Statements included elsewhere
in this Report.
SALES AND DISTRIBUTION
Our sales and distribution is handled by Vivendi in North America and
selected rest-of-world countries and by Virgin in Europe, the Commonwealth of
Independent States, Africa and the Middle East and through licensing strategies
elsewhere. We also distribute our software products through on line services.
North America. In August 2001, we entered into a distribution agreement
with Vivendi providing for Vivendi to become our distributor in North America
through December 31, 2003 for substantially all of our products, with the
exception of products with pre-existing distribution agreements. OEM rights were
not among the rights granted to Vivendi under the distribution agreement. Under
the terms of the agreement, as amended, Vivendi earned a distribution fee based
on the net sales of the titles distributed. Under the agreement, as amended,
Vivendi made four advance payments to us totaling $13.5 million. Vivendi
recouped these advances from sales of our products in 2002 and we repaid a
portion of the advances with the proceeds received from the sale of Shiny.
In August 2002, we entered into a new distribution arrangement with
Vivendi, whereby, Vivendi will distribute substantially all of our products in
North America for a period of three years as a whole and two years with respect
to each product providing for a potential maximum term of five years. Under the
August 2002 agreement, Vivendi will pay us sales proceeds less amounts for
distribution fees, price concessions and returns. Vivendi is responsible for all
manufacturing, marketing and distribution expenditures, and bears all credit,
price concessions and inventory risk, including product returns. Upon our
delivery of a gold master to Vivendi, Vivendi will pay us, as a non-refundable
minimum guarantee, a specified percent of the projected amount due to us based
on projected initial shipment sales, which are established by Vivendi in
accordance with the terms of the agreement. The remaining amounts are due upon
shipment of the titles to Vivendi's customers. Payments for future sales that
exceed the projected initial shipment sales are paid on a monthly basis. We also
continue to distribute products directly to end-users who can order products by
7
using a toll-free number or by accessing our web site. Prior to entering into
our original North America distribution agreement with Vivendi, in North America
we sold our products primarily to mass merchants, warehouse club stores, large
computer and software specialty retail chains and through catalogs and Internet
commerce sites. A majority of our North American retail sales were to direct
accounts, and a lesser percentage were to third party distributors. Our
principal direct retail accounts included CompUSA, Best Buy, Electronics
Boutique, Wal-Mart, K-Mart, Target, Toys-r-us and GameStop (Babbages). Our
principal distributors in North America included Navarre and Softek. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Factors Affecting Future Performance--A significant percentage of
our revenues depend on our distributors' diligent sales efforts and our
distributors' and retail customers' timely payments to us."
Our distributor seeks to extend the life cycle and financial return of many
of our products by marketing those products differently during the various
stages of the product's sales cycle. Although the product sales cycle for a
title varies based on a number of factors, including the quality of the title,
the number and quality of competing titles, and in certain instances
seasonality, we typically consider a title to be a "back catalog" item once it
incurs its first price drop after its initial release. Our distributor utilizes
marketing programs appropriate for each particular title, which generally
include progressive price reductions over time to increase the product's
longevity in the retail channel as they shift their advertising support to newer
releases.
Our distributor provides terms of sale comparable to competitors in our
industry. In addition, we provide technical support for our products in North
America through our customer support and we provide a 90-day limited warranty to
end-users that our products will be free from manufacturing defects. While to
date we have not experienced any material warranty claims, there can be no
assurance that we will not experience material warranty claims in the future.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations--Factors Affecting Future Performance--A significant percentage of
our revenues depend on our distributors' diligent sales efforts and our
distributors' and retail customers' timely payments to us."
International. In February 1999, we entered into a distribution agreement
with Virgin, pursuant to which Virgin commenced distributing substantially all
of our titles in Europe, the Commonwealth of Independent States, Africa and the
Middle East for a seven year period. Under the agreement, as amended, Virgin
earns a distribution fee for its marketing and distribution of our products, and
we reimburse Virgin for certain direct costs and expenses. In February 2003,
Virgin's operating subsidiary filed for a Company Voluntary Agreement, or CVA, a
process of reorganization in the United Kingdom. As of March 28, 2003, the CVA
was rejected by Virgin's creditors, and Virgin is presently negotiating with its
creditors to propose a new CVA. If a new CVA is not approved, we expect Virgin
to cease operations and liquidate, in which event we will not have a distributor
for our products in Europe and the other territories in which Virgin presently
distributes our products. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future Performance--A
significant percentage of our revenues depend on our distributors' diligent
sales efforts and our distributors' and retail customers' timely payments to
us."
In January 2003, we entered into an agreement with Vivendi to distribute
substantially all of our products in select rest-of-world countries.
Interplay OEM. Our wholly owned subsidiary, Interplay OEM, distributes our
interactive entertainment software titles, as well as those of other software
publishers, to computer and peripheral device manufacturers for use in bundling
arrangements. As a result of changes in market conditions for bundling
arrangements and the limited amount of resources we have available, we no longer
have any personnel applying their efforts towards bundling arrangements. In
December 2002, we assigned our OEM distribution rights to Vivendi and will
utilize Vivendi's resources in our future OEM business. Under OEM arrangements,
one or more software titles, which are either limited-feature versions or the
retail version of a game, are bundled with computer or peripheral devices and
are sold by an original equipment manufacturer so that the purchaser of the
hardware device obtains the software as part of the hardware purchase. Although
it is customary for OEM customers to pay a lower per unit price on sales through
OEM bundling contracts, such arrangements involve a high unit volume commitment.
Interplay OEM net revenues generally are incremental net revenues and do not
have significant additional product development or sales and marketing costs.
Our North American and International ultimate distribution channels are
characterized by continuous change, including consolidation, financial
difficulties of certain retailers, and the emergence of new distributors and new
retail
8
channels such as warehouse chains, mass merchants, computer superstores and
Internet commerce sites. Under the terms of some of our distribution agreements,
we are exposed to the risk of product returns and markdown allowances by our
distributors. Under the same distribution agreements, we allow our distributors
to return defective, shelf-worn and damaged products in accordance with
negotiated terms. We also offer a 90-day limited warranty to our end users that
our products will be free from manufacturing defects. In addition, our
distributors provide markdown allowances, which consist of credits given to
resellers to induce them to lower the retail sales price of certain of our
products to increase sell through and to help the reseller manage its inventory
levels. Although we maintain a reserve for returns and markdown allowances, and
although we manage our returns and markdown allowances through an authorization
procedure, we could be forced to accept substantial product returns and provide
markdown allowances to maintain our access to certain distribution channels. Our
reserve for estimated returns, exchanges, markdowns, price concessions, and
warranty costs was $1.1 million and $7.5 million at December 31, 2002 and 2001,
respectively. Product returns and markdown allowances that exceed our reserves,
if any, could have a material adverse effect on our business, operating results
and financial condition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future Performance--A
significant percentage of our revenues depend on our distributors' diligent
sales efforts and our distributors' and retail customers' timely payments to
us."
MARKETING
Our marketing department assists our distributors in the development and
implementation of marketing programs and campaigns for each of our titles and
product groups. Our distributors' marketing activities in preparation for a
product launch include print advertising, game reviews in consumer and trade
publications, retail in-store promotions, attendance at trade shows and public
relations. Our distributors also send direct and electronic mail promotional
materials to our database of gamers, and may selectively use radio and
television advertisements in connection with the introduction of certain of our
products. Our distributors budget a portion of each product's sales for
cooperative advertising and market development funds with retailers. Every title
and brand is launched with a multi-tiered marketing campaign that is developed
on an individual basis to promote product awareness and customer pre-orders.
Our distributors engage in on-line marketing through Internet advertising
and the maintenance of several Internet web sites. These web sites provide news
and information of interest to our customers through free demonstration versions
of games, contests, games, tournaments and promotions. Also, to generate
interest in new product introductions, we provide free demonstration versions of
upcoming titles through magazines and game samples that consumers can download
from our web site. In addition, through our marketing department, we host
on-line events and maintain a vast collection of message boards to keep
customers informed on shipped and upcoming titles.
COMPETITION
The interactive entertainment software industry is intensely competitive
and is characterized by the frequent introduction of new hardware systems and
software products. Our competitors vary in size from small companies to very
large corporations with significantly greater financial, marketing and product
development resources than ours. Due to these greater resources, certain of our
competitors are able to undertake more extensive marketing campaigns, adopt more
aggressive pricing policies, pay higher fees to licensors of desirable motion
picture, television, sports and character properties and pay more to third party
software developers than us. We believe that the principal competitive factors
in the interactive entertainment software industry include product features,
brand name recognition, access to distribution channels, quality, ease of use,
price, marketing support and quality of customer service.
We compete primarily with other publishers of PC and video game console
interactive entertainment software. Significant competitors include Electronic
Arts Inc., Take Two Interactive Software Inc, THQ Inc., The 3DO Company, Eidos
PLC, Infogrames Entertainment, Activision, Inc., Microsoft Corporation,
LucasArts Entertainment Company, Midway Games Inc., Acclaim Entertainment, Inc.,
Vivendi Universal Games, Inc. and Ubi Soft Entertainment Inc. In addition,
integrated video game console hardware/software companies such as Sony Computer
Entertainment, Microsoft Corporation, Nintendo and Sega compete directly with us
in the development of software titles for their respective platforms. Large
diversified entertainment companies, such as The Walt Disney Company, many of
which own substantial libraries of available content and have substantially
greater financial resources than us, may decide to compete directly with us or
to enter into exclusive relationships with our competitors. We also believe that
the overall growth in the use of the Internet and on-line services by consumers
may pose a competitive threat if customers and potential
9
customers spend less of their available time using interactive entertainment
software and more time on the Internet and on-line services.
Retailers of our products typically have a limited amount of shelf space
and promotional resources. Consequently, there is intense competition among
consumer software producers, and in particular interactive entertainment
software producers, for high quality retail shelf space and promotional support
from retailers. If the number of consumer software products and computer
platforms increase, competition for shelf space will intensify which may require
us to increase our marketing expenditures. This increased demand for limited
shelf space, places retailers and distributors in an increasingly better
position to negotiate favorable terms of sale, including price discounts, price
protection, marketing and display fees and product return policies. As our
products constitute a relatively small percentage of any retailer's sales
volume, there can be no assurance that retailers will continue to purchase our
products or provide our products with adequate shelf space and promotional
support. A prolonged failure by retailers to provide shelf space and promotional
support would have a material adverse effect on our business, operating results
and financial condition.
MANUFACTURING
Our PC-based products consist primarily of CD-ROMs and DVDs, manuals, and
packaging materials. Substantially all of our CD-ROM and DVD duplication is
performed by unaffiliated third parties. Printing of manuals and packaging
materials, manufacturing of related materials and assembly of completed packages
are performed to our specifications by unaffiliated third parties. To date, we
have not experienced any material difficulties or delays in the manufacture and
assembly of our CD-ROM and DVD based products, and we have not experienced
significant returns due to manufacturing defects.
Sony Computer Entertainment, Microsoft Corporation and Nintendo manufacture
and ship finished products that are compatible with their video game consoles to
our distributors for distribution. PlayStation 2, Xbox and GameCube products
consist of the game disks and include manuals and packaging and are typically
delivered within a relatively short lead-time.
If we experience unanticipated delays in the delivery of manufactured
software products by our third party manufactures, our net sales and operating
results could be materially adversely affected. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Factors Affecting
Future Performance--Our sales volume and the success of our products depend in
part upon the number of product titles distributed by hardware companies for use
with their video game platforms."
INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS
We hold copyrights on our products, product literature and advertising and
other materials, and hold trademark rights in our name and certain of our
product names and publishing labels. We have licensed certain products to third
parties for distribution in particular geographic markets or for particular
platforms, and receive royalties on such licenses. We also outsource some of our
product development activities to third party developers, contractually
retaining all intellectual property rights related to such projects. We also
license certain products developed by third parties and pay royalties on such
products. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Our reliance on third party software developers subjects
us to the risks that these developers will not supply us with high quality
products in a timely manner or on acceptable terms."
We regard our software as proprietary and rely primarily on a combination
of patent, copyright, trademark and trade secret laws, employee and third party
nondisclosure agreements and other methods to protect our proprietary rights. We
own or license various copyrights and trademarks. While we provide "shrinkwrap"
license agreements or limitations on use with our software, the enforceability
of such agreements or limitations is uncertain. We are aware that unauthorized
copying occurs within the computer software industry, and if a significantly
greater amount of unauthorized copying of our interactive entertainment software
products were to occur, our operating results could be materially adversely
affected. We use copy protection on selected products and do not provide source
code to third parties unless they have signed nondisclosure agreements.
10
We rely on existing copyright laws to prevent the unauthorized distribution
of our software. Existing copyright laws afford only limited protection.
Policing unauthorized use of our products is difficult, and we expect software
piracy to be a persistent problem, especially in certain international markets.
Further, the laws of certain countries in which our products are or may be
distributed either do not protect our products and intellectual property rights
to the same extent as the laws of the U.S. or are weakly enforced. Legal
protection of our rights may be ineffective in such countries, and as we
leverage our software products using emerging technologies, such as the Internet
and on-line services, our ability to protect our intellectual property rights,
and to avoid infringing the intellectual property rights of others, becomes more
difficult. In addition, the intellectual property laws are less clear with
respect to such emerging technologies. There can be no assurance that existing
intellectual property laws will provide our products with adequate protection in
connection with such emerging technologies.
As the number of software products in the interactive entertainment
software industry increases and the features and content of these products
further overlap, interactive entertainment software developers may increasingly
become subject to infringement claims. Although we take reasonable efforts to
ensure that our products do not violate the intellectual property rights of
others, there can be no assurance that claims of infringement will not be made.
Any such claims, with or without merit, can be time consuming and expensive to
defend. From time to time, we have received communications from third parties
asserting that features or content of certain of our products may infringe upon
such party's intellectual property rights. There can be no assurance that
existing or future infringement claims against us will not result in costly
litigation or require that we license the intellectual property rights of third
parties, either of which could have a material adverse effect on our business,
operating results and financial condition. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Factors Affecting
Future Performance--We may unintentionally infringe on the intellectual property
rights of others, which could expose us to substantial damages or restrict our
operations."
EMPLOYEES
As of December 31, 2002, we had 207 employees, including 157 in product
development, 11 in sales and marketing and 36 in finance, general and
administrative. Included in these counts are 2 employees of Interplay OEM and 1
employee of Interplay UK. We also retain independent contractors to provide
certain services, primarily in connection with our product development
activities. Neither we nor our full time employees are subject to any collective
bargaining agreements and we believe that our relations with our employees are
good.
From time to time, we have retained actors and/or "voice over" talent to
perform in certain of our products, and we expect to continue this practice in
the future. These performers are typically members of the Screen Actors Guild or
other performers' guilds, which guilds have established collective bargaining
agreements governing their members' participation in interactive media projects.
We may be required to become subject to one or more of these collective
bargaining agreements in order to engage the services of these performers in
connection with future development projects.
Item 2. PROPERTIES
Our headquarters are located in Irvine, California, where we lease
approximately 81,000 square feet of office space. This lease expires in June
2006 and provides us with one five year option to extend the term of the lease
and expansion rights, on an "as available basis," to approximately double the
size of the office space. In addition, we rent approximately 800 square feet of
office space in Central London, England from Virgin. This agreement is on a
quarter by quarter basis. We believe that our facilities are adequate for our
current needs and that suitable additional or substitute space will be available
in the future to accommodate potential expansion of our operations.
Item 3. LEGAL PROCEEDINGS
We are occasionally involved in various legal proceedings, claims and
litigation arising in the ordinary course of business, including disputes
arising over the ownership of intellectual property rights and collection
matters. We do not believe the outcome of such routine claims will have a
material adverse effect on the Company's business, financial condition or
results of operations.
11
On September 16, 2002, Knight Bridging Korea Co., Ltd ("KBK") filed a $98.8
million complaint for damages against both Infogrames, Inc. and our subsidiary
GamesOnline.com, Inc., alleging, among other things, breach of contract,
misappropriation of trade secrets, breach of fiduciary duties and breach of
implied covenant of good faith in connection with an electronic distribution
agreement dated November 2001 between KBK and GamesOnline.com, Inc. KBK has
alleged that GamesOnline.com failed to timely deliver to KBK assets to a
product, and that it improperly disclosed confidential information about KBK to
Infogrames. We believe this complaint is without merit and will vigorously
defend our position.
On November 25, 2002, Special Situations Fund III, Special Situations
Cayman Fund, L.P., Special Situations Private Equity Fund, L.P., and Special
Situations Technology Fund, L.P. (collectively, "Special Situations") filed a
motion for summary judgment in lieu of complaint against us in the amount of
$1.3 million, alleging, among other things, that we are liable to pay Special
Situations $1.3 million for our failure to timely register for resale with the
Securities and Exchange Commission certain shares of our common stock that
Special Situations purchased from us in April 2001. We dispute the amount of the
claim and will vigorously defend our position.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On October 10, 2002, the Company held its annual stockholders' meeting.
There were 93,138,176 shares of Common Stock outstanding entitled to vote and a
total of 82,350,413 shares (88.4%) were represented at the meeting in person or
by proxy. The following summarizes vote results of proposals submitted to the
Company's stockholders.
1. Proposal to elect directors, each for a term extending until the next annual
meeting of Stockholders or until their successors are duly elected and
qualified.
For Withheld
---------- --------
Herve Caen................................ 81,982,528 367,885
Nathan Peck............................... 81,548,426 801,987
Michel Welter............................. 82,121,096 229,317
R. Parker Jones........................... 82,124,012 226,401
Eric Caen................................. 81,987,528 326,885
Michel H. Vulpillat....................... 82,019,427 330,986
Maren Stenseth............................ 81,627,672 772,801
2. Proposal to amend the Company's 1997 Stock Incentive Plan to increase the
number of authorized shares by 6,000,000 shares.
For Against Abstain Broker Non-Votes
--- ------- ------- ----------------
57,523,156 1,966,938 179,769 22,680,550
12
3. Proposal to amend the Company's Amended and Restated Certificate of
Incorporation to effect a one-for-ten reverse stock split of shares of the
Company's Common Stock.
For Against Abstain Broker Non-Votes
--- ------- ------- ----------------
81,599,812 573,226 177,375 -0-
Although this proposal was approved by the stockholders, the Company has not
taken action on the proposal.
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
On May 16, 2002, the listing of our common stock was moved from the Nasdaq
National Market System to the Nasdaq SmallCap Market System. We had until August
13, 2002 to comply with the requirements of the SmallCap market. As a result of
our inability to maintain certain minimum listing requirements of the SmallCap
market, on October 9, 2002, our common stock was delisted and began trading on
the NASD-operated Over-the-Counter Bulletin Board. Our common stock is currently
traded on the NASD-operated Over-the-Counter Bulletin Board under the symbol
"IPLY.OB." At December 31, 2002, there were 110 holders of record of our common
stock.
The following table sets forth the range of high and low sales prices for
our common stock for the periods indicated.
For the Year ended December 31, 2002 High Low
- ------------------------------------ -------- --------
First Quarter ........................ $ 0.61 $ 0.18
Second Quarter ....................... 0.59 0.24
Third Quarter ........................ 0.41 0.12
Fourth Quarter ....................... 0.13 0.06
For the Year ended December 31, 2001 High Low
- ------------------------------------ -------- --------
First Quarter ........................ $ 3.25 $ 1.50
Second Quarter ....................... 3.11 1.33
Third Quarter ........................ 2.20 0.33
Fourth Quarter ....................... 0.96 0.31
DIVIDEND POLICY
We have never paid any dividends on our common stock. We intend to retain
any earnings for use in our business and do not intend to pay any cash dividends
on our common stock in the foreseeable future.
13
EQUITY COMPENSATION PLANS INFORMATION
The following table sets forth certain information regarding the Company's
equity compensation plans as of December 31, 2002.
Plan Category Number of securities to Weighted-average Number of securities
be issued upon exercise exercise price of remaining available for
of outstanding options, outstanding options, future issuance under equity
warrants and rights warrants and rights compensation plans
(excluding securities
reflected in column (a))
- --------------------------------------------------------------------------------------------------------
(a) (b) (c)
Equity compensation plans 1,091,697 3.10 3,209,735
approved by security
holders
Equity compensation plans - - -
not approved by security
holders
-----------------------------------------------------------------------------
Total 1,091,697 3.10 3,209,735
=============================================================================
14
Item 6. SELECTED FINANCIAL DATA
The selected consolidated statements of operations data for the years ended
December 31, 2002, 2001 and 2000 and the selected consolidated balance sheets
data as of December 31, 2002 and 2001 are derived from our audited consolidated
financial statements included elsewhere in this Form 10-K. The selected
consolidated statements of operations data for the years ended December 31, 1999
and 1998 and the selected consolidated balance sheets data as of December 31,
2000, 1999 and 1998 are derived from our audited consolidated financial
statements not included in this Form 10-K. Our historical results are not
necessarily indicative of the results that may be achieved for any other period.
The following data should be read in conjunction with "Management's Discussion
and Analysis of Financial Condition and Results of Operations" and the
Consolidated Financial Statements included elsewhere in this Form 10-K.
Years Ended December 31,
-------------------------------------------------------------
2002 2001 2000 1999 1998
--------- --------- --------- --------- ---------
(Dollars in thousands, except per share amounts)
Statements of Operations Data:
Net revenues ......................... $ 43,999 $ 56,448 $ 101,426 $ 101,930 $ 126,862
Cost of goods sold ................... 26,706 45,816 54,061 61,103 71,928
--------- --------- --------- --------- ---------
Gross profit ......................... 17,293 10,632 47,365 40,827 54,934
Operating expenses:
Marketing and sales ............. 5,814 18,697 23,326 32,432 39,471
General and administrative ...... 7,655 12,622 10,249 18,155 12,841
Product development ............. 16,184 20,603 22,176 20,629 24,472
Other ........................... -- -- -- 2,415 --
--------- --------- --------- --------- ---------
Total operating expenses ........ 29,653 51,922 55,751 73,631 76,784
--------- --------- --------- --------- ---------
Operating loss ....................... (12,360) (41,290) (8,386) (32,804) (21,850)
Sale of Shiny ........................ 28,813 -- -- -- --
Other income (expense) ............... (1,531) (4,526) (3,689) (3,471) (4,933)
--------- --------- --------- --------- ---------
Income (loss) before income taxes .... 14,922 (45,816) (12,075) (36,275) (26,783)
Provision (benefit) for income taxes . (225) 500 -- 5,410 1,437
--------- --------- --------- --------- ---------
Net income (loss) .................... $ 15,147 $ (46,316) $ (12,075) $ (41,685) $ (28,220)
========= ========= ========= ========= =========
Cumulative dividend on participating
preferred stock ................. $ 133 $ 966 $ 870 $ -- $ --
Accretion of warrant ................. -- 266 532 -- --
--------- --------- --------- --------- ---------
Net income (loss) available to common
stockholders .................... $ 15,014 $ (47,548) $ (13,477) $ (41,685) $ (28,220)
========= ========= ========= ========= =========
Net income (loss) per common share:
Basic ........................... $ 0.18 $ (1.23) $ (0.45) $ (1.86) $ (1.91)
Diluted ......................... $ 0.16 $ (1.23) $ (0.45) $ (1.86) $ (1.91)
Shares used in calculating net income
(loss) per common share - basic . 83,585 38,670 30,047 22,418 14,763
Shares used in calculating net income
(loss) per common share - diluted 96,070 38,670 30,047 22,418 14,763
Selected Operating Data:
Net revenues by geographic region:
North America ................... $ 26,184 $ 34,998 $ 53,298 $ 49,443 $ 73,865
International ................... 5,674 15,451 35,077 30,310 35,793
OEM, royalty and licensing ...... 12,141 5,999 13,051 22,177 17,204
Net revenues by platform:
Personal computer ............... $ 15,802 $ 34,912 $ 73,730 $ 65,397 $ 67,406
Video game console .............. 16,056 15,537 14,645 14,356 42,252
OEM, royalty and licensing ...... 12,141 5,999 13,051 22,177 17,204
December 31,
-------------------------------------------------------------
2002 2001 2000 1999 1998
--------- --------- --------- --------- ---------
Balance Sheets Data: (Dollars in thousands)
Working capital (deficiency) ......... $ (17,060) $ (34,169) $ 123 $ (7,622) $ (3,135)
Total assets ......................... 14,298 31,106 59,081 56,936 74,944
Total debt ........................... 2,082 4,794 25,433 19,630 24,651
Stockholders' equity (deficit) ...... (13,930) (28,150) 6,398 (2,071) 4,193
15
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
You should read the following discussion and analysis in conjunction with
the Consolidated Financial Statements and notes thereto and other information
included or incorporated by reference herein.
GENERAL
We derive net revenues primarily from sales of software products to
distributors in North America and internationally, and from sales of software
products to end-users through our catalogs and the Internet. We also derive
royalty-based revenues from licensing arrangements and from original equipment
manufacturing, or OEM bundling transactions.
During 2002 we continued to experience cash flow difficulties from
operations, and relied upon sales of assets to pay liabilities, reduce future
operational costs and und our ongoing operations. We have been operating without
a credit facility since October 2001, which has adersely affected cash flow. We
continue to face difficulties in paying our vendors and have pending lawsuits as
a result of our continuing cash flow difficulties. We expect these difficulties
to continue during 2003.
In February 2003, Virgin Interactive Entertainment (Europe) Limited,, the
operating subsidiary of Virgin Interactive Entertainment Limited ("Virgin"), our
European distributor, filed for a Company Voluntary Arrangement, or CVA, a
process of reorganization in the United Kingdom which must be approved by
Virgin's creditors. Virgin owed us approximately $1.8 million at December 31,
2002. As of March 28, 2003, the CVA was rejected by Virgin's creditors, and
Virgin is presently negotiating with its creditors to propose a new CVA. We do
not know what affect approval of the CVA will have on our ability to collect
amounts Virgin owes us. If the new CVA is not approved, we expect Virgin to
cease operations and liquidate, in which event we will most likely not receive
any amounts presently due us by Virgin, and will not have a distributor for our
products in Europe and the other territories in which Virgin presently
distributes our products.
In February 2003, we amended our license agreement with Infogrames, the
holder of the TSR license which we rely on to publish the Baldur's Gate,
Baldur's Gate: Dark Alliance, and Icewind Dale titles, to, among other things,
(i) extend the license term for approximately an additional two years to
December 31, 2008 (provided we make a timely extension payment required for such
extension), and (ii) extend our rights with respect to certain of the Advanced
Dungeons & Dragons properties. The amendment further terminates our rights to
certain titles in the event Interplay is unable to obtain certain third-party
waivers in accordance with the terms of the amendment. We were unable to obtain
the required waivers within the permitted time period and as a result have lost
rights to publish Baldur's Gate 3 and its sequels on the PC, a significant
product franchise. We are in negotiations with Infogrames to reinstate these
rights, but no assurance can be given that we will be successful.
We have been able to retain our third party developers to date, but if our
current liquidity issues continue, our future title development could be
adversely affected.
In August 2001, we entered into a distribution agreement with Vivendi
Universal Games, Inc. (an affiliate company of Universal Studios, Inc., who as
of today owns approximately 5 percent of our common stock) providing for Vivendi
to become our distributor in North America through December 31, 2003 for
substantially all of our products, with the exception of products with
pre-existing distribution agreements. OEM rights were not among the rights
granted to Vivendi under the distribution agreement. Under the terms of the
agreement, as amended, Vivendi earned a distribution fee based on the net sales
of the titles distributed. Under the agreement, as amended, Vivendi made four
advance payments to us totaling $13.5 million. Vivendi recouped these advances
from sales of our products in 2002 and we repaid a portion of the advances with
the proceeds received from the sale of Shiny. In an effort to minimize the
number of product returns following the transition of our North America
distribution to Vivendi, we granted large price concessions to resellers on
products in their inventory. As we continue to conclude our relations these
resellers, we have decreased our sales allowances from 44 percent of our total
accounts receivable in 2001 to 29 percent of our total accounts receivable in
2002.
16
In August 2002, we entered into a new distribution arrangement with Vivendi
whereby Vivendi will distribute substantially all of our products in North
America for a period of three years as a whole and two years with respect to
each product providing for a potential maximum term of five years. Under the
August 2002 agreement, Vivendi will pay us sales proceeds less amounts for
distribution fees, price concessions and returns. Vivendi is responsible for all
manufacturing, marketing and distribution expenditures, and bears all credit,
price concessions and inventory risk, including product returns. Upon our
delivery of a gold master to Vivendi, Vivendi will pay us, as a non-refundable
minimum guarantee, a specified percent of the projected amount due to us based
on projected initial shipment sales, which are established by Vivendi in
accordance with the terms of the agreement. The remaining amounts are due upon
shipment of the titles to Vivendi's customers. Payments for future sales that
exceed the projected initial shipment sales are paid on a monthly basis. We
expect this new arrangement to improve our short-term liquidity, but should not
impact our overall liquidity. Under this new distribution arrangement, we expect
our net revenues to decrease as a result of incurring a higher commission
expense, however, we expect our operating margins to remain comparable to prior
periods as we are no longer incurring any manufacturing, marketing or
distribution expenditures.
Our wholly-owned subsidiary, Interplay OEM, distributed our interactive
entertainment software titles, as well as those of other software publishers, to
computer and peripheral device manufacturers for use in bundling arrangements.
As a result of changes in the market conditions for bundling arrangements and
the limited amount of resources we have available, we no longer have any
personnel applying their efforts towards bundling arrangements. In December
2002, we licensed our OEM distribution rights to Vivendi and will utilize
Vivendi's resources in our future OEM business. We also derive net revenues from
the licensing of intellectual property and products to third parties for
distribution in markets and through channels that are outside of our primary
focus. OEM, royalty and licensing net revenues collectively accounted for 27
percent of net revenues for the year ended December 31, 2002, 11 percent for the
year ended December 31, 2001, and 13 percent for the year ended December 31,
2000. OEM, royalty and licensing net revenues generally are incremental net
revenues and do not have significant additional product development or sales and
marketing costs.
Cost of goods sold related to PC and video game console net revenues
represents the manufacturing and related costs of interactive entertainment
software products, including costs of media, manuals, duplication, packaging
materials, assembly, freight and royalties paid to developers, licensors and
hardware manufacturers. For sales of titles under the new distribution
arrangement with Vivendi, our cost of goods consists of royalties paid to
developers. Cost of goods sold related to royalty-based net revenues primarily
represents third party licensing fees and royalties paid by us. Typically, cost
of goods sold as a percentage of net revenues for video game console products
are higher than cost of goods sold as a percentage of net revenues for PC based
products due to the relatively higher manufacturing and royalty costs associated
with video game console and affiliate label products. We also include in the
cost of goods sold the amortization of prepaid royalty and license fees we pay
to third party software developers. We expense prepaid royalties over a period
of six months commencing with the initial shipment of the title at a rate based
upon the numbers of units shipped. We evaluate the likelihood of future
realization of prepaid royalties and license fees quarterly, on a
product-by-product basis, and charge the cost of goods sold for any amounts that
we deem unlikely to realize through future product sales.
Our operating results have fluctuated significantly in the past and likely
will fluctuate significantly in the future, both on a quarterly and an annual
basis. A number of factors may cause or contribute to such fluctuations, and
many of such factors are beyond our control. We cannot assure you that we will
be profitable in any particular period. It is likely that our operating results
in one or more future periods will fail to meet or exceed the expectations of
securities analysts or investors. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Factors Affecting Future
Performance -The unpredictability of future results may cause our stock price to
remain depressed or to decline further."
Our operating results will continue to be impacted by economic, industry
and business trends affecting the interactive entertainment industry. Our
industry is highly seasonal, with the highest levels of consumer demand
occurring during the year-end holiday buying season. With the release of next
generation console systems by Sony, Nintendo and Microsoft, our industry has
entered into a growth period that could be sustained for the next couple of
years.
The accompanying consolidated financial statements have been prepared
assuming that we will continue as a going concern, which contemplates the
realization of assets and the satisfaction of liabilities in the normal course
of business. The carrying amounts of assets and liabilities presented in the
financial statements do not purport to represent realizable
17
or settlement values. The Report of our Independent Auditors for the December
31, 2002 consolidated financial statements includes an explanatory paragraph
expressing substantial doubt about our ability to continue as a going concern.
MANAGEMENT'S DISCUSSION OF CRITICAL ACCOUNTING POLICIES
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those
related to revenue recognition, prepaid licenses and royalties and software
development costs. We base our estimates on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances,
the results of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different
assumptions or conditions. We believe the following critical accounting policies
affect our more significant judgments and estimates used in preparation of our
consolidated financial statements.
Revenue Recognition
We record revenues when we deliver products to customers in accordance with
Statement of Position ("SOP") 97-2, "Software Revenue Recognition." and SEC
Staff Accounting Bulletin No. 101, Revenue Recognition. Commencing in August
2001, substantially all of our sales are made by two related party distributors,
Vivendi Universal Games, Inc. and Virgin Interactive Entertainment Ltd. We
recognize revenue from sales by distributors, net of sales commissions, only as
the distributor recognizes sales of our products to unaffiliated third parties.
For those agreements that provide the customers the right to multiple copies of
a product in exchange for guaranteed amounts, we recognize revenue at the
delivery and acceptance of the product master. We recognize per copy royalties
on sales that exceed the guarantee as copies are duplicated.
We generally are not contractually obligated to accept returns, except for
defective, shelf-worn and damaged products. However, on a case-by-case
negotiated basis, we permit customers to return or exchange product and may
provide price concessions to our retail distribution customers on unsold or slow
moving products. In accordance with Statement of Financial Accounting Standards
("SFAS") No. 48, "Revenue Recognition when Right of Return Exists," we record
revenue net of a provision for estimated returns, exchanges, markdowns, price
concessions, and warranty costs. We record such reserves based upon management's
evaluation of historical experience, current industry trends and estimated
costs. During 2001, we substantially increased our sales allowances as a result
of the granting of price concessions to resellers on products in their
inventory, in an effort to minimize product returns following the transition of
our North American distribution rights to Vivendi. As a result, sales allowances
as a percentage of our total accounts receivable increased to 44 percent at
December 31, 2001 from 19 percent at December 31, 2000. With the transition to
Vivendi complete, sales allowances as a percentage of sales decreased to 29
percent at December 31, 2002. The amount of reserves ultimately required could
differ materially in the near term from the amounts provided in the accompanying
consolidated financial statements.
We provide customer support only via telephone and the Internet. Customer
support costs are not significant and we charge such costs to expenses as we
incur them.
We also engage in the sale of licensing rights on certain products. The
terms of the licensing rights differ, but normally include the right to develop
and distribute a product on a specific video game platform. Revenue is
recognized when the rights have been transferred and no other obligations exist.
Prepaid Licenses and Royalties
Prepaid licenses and royalties consist of license fees paid to intellectual
property rights holders for use of their trademarks or copyrights. Also included
in prepaid royalties are prepayments made to independent software developers
under developer arrangements that have alternative future uses. These payments
are contingent upon the successful
18
completion of milestones, which generally represent specific deliverables.
Royalty advances are recoupable against future sales based upon the contractual
royalty rate. We amortize the cost of licenses, prepaid royalties and other
outside production costs to cost of goods sold over six months commencing with
the initial shipment in each region of the related title. We amortize these
amounts at a rate based upon the actual number of units shipped with a minimum
amortization of 75 percent in the first month of release and a minimum of 5
percent for each of the next five months after release. This minimum
amortization rate reflects our typical product life cycle. Management evaluates
the future realization of such costs quarterly and charges to cost of goods sold
any amounts that management deems unlikely to be fully realized through future
sales. Such costs are classified as current and noncurrent assets based upon
estimated product release date.
Software Development Costs
Our internal research and development costs, which consist primarily of
software development costs, are expensed as incurred. Statement of Financial
Accounting Standards ("SFAS") No. 86, "Accounting for the Cost of Computer
Software to be Sold, Leased, or Otherwise Marketed", provides for the
capitalization of certain software development costs incurred after
technological feasibility of the software is established or for development
costs that have alternative future uses. Under our current practice of
developing new products, the technological feasibility of the underlying
software is not established until substantially all of the product development
is complete. As a result, we have not capitalized any software development costs
on internal development projects, as the eligible costs were determined to be
insignificant.
Other Significant Accounting Policies
Other significant accounting policies not involving the same level of
measurement uncertainties as those discussed above, are nevertheless important
to an understanding of the financial statements. The policies related to
consolidation and loss contingencies require difficult judgments on complex
matters that are often subject to multiple sources of authoritative guidance.
Certain of these matters are among topics currently under reexamination by
accounting standards setters and regulators. Although no specific conclusions
reached by these standard setters appear likely to cause a material change in
our accounting policies, outcomes cannot be predicted with confidence. Also see
Note 2 of Notes to Consolidated Financial Statements, Summary of Significant
Accounting Policies, which discusses accounting policies that must be selected
by management when there are acceptable alternatives.
19
RESULTS OF OPERATIONS
The following table sets forth certain consolidated statements of
operations data and segment and platform data for the periods indicated
expressed as a percentage of net revenues:
Years Ended December 31,
2002 2001 2000
---- ---- ----
Statements of Operations Data:
Net revenues ............................... 100% 100% 100%
Cost of goods sold ......................... 61 81 53
---- ---- ----
Gross margin ............................... 39 19 47
Operating expenses:
Marketing and sales ................... 13 33 23
General and administrative ............ 17 22 10
Product development ................... 37 37 22
---- ---- ----
Total operating expenses .............. 67 92 55
---- ---- ----
Operating loss ............................. (28) (73) (8)
Other income (expense) ..................... 62 (8) (4)
---- ---- ----
Income (loss) before provision
for income taxes ........................ 34 (81) (12)
Provision for income taxes ................. -- 1 --
---- ---- ----
Net income (loss) .......................... 34% (82)% (12)%
==== ==== ====
Selected Operating Data:
Net revenues by segment:
North America ......................... 60% 62% 52%
International ......................... 13 27 35
OEM, royalty and licensing ............ 27 11 13
---- ---- ----
100% 100% 100%
==== ==== ====
Net revenues by platform:
Personal computer ..................... 36% 62% 73%
Video game console .................... 37 27 14
OEM, royalty and licensing ............ 27 11 13
---- ---- ----
100% 100% 100%
==== ==== ====
North American, International and OEM, Royalty and Licensing Net Revenues
Net revenues for the year ended December 31, 2002 were $44.0 million, a
decrease of 22 percent compared to the same period in 2001. This decrease
resulted from a 25 percent decrease in North American net revenues, a 63 percent
decrease in International net revenues, offset by a 102 percent increase in OEM,
royalties and licensing revenues. Net revenues for the year ended December 31,
2001 were $56.4 million, a decrease of 44 percent compared to the same period in
2000. This decrease resulted from a 34 percent decrease in North American net
revenues, a 56 percent decrease in International net revenues and a 54 percent
decrease in OEM, royalties and licensing revenues.
North American net revenues for the year ended December 31, 2002 were $26.2
million. The decrease in North American net revenues in 2002 was mainly due to
lower total units sales as a result of releasing 6 titles in 2002 compared to 8
titles in 2001. Furthermore, five of the titles were released by Vivendi under
the terms of the new distribution agreement, whereby Vivendi pays us a lower per
unit rate and in return assumes all credit, product return and price concession
risks, as well as being responsible for all manufacturing, marketing and
distribution expenditures. These resulted in a decrease in North American sales
of $18.3 million, partially offset by a decrease in product returns and price
concessions of $9.5 million as compared to the 2001 period. The decrease in
title releases across all platforms is a result of our continued focus on
product planning and the releasing of fewer, higher quality titles. Our returns
were lower in 2002 due primarily to price concessions we granted in 2001 in
connection with the North American Distribution Agreement we entered into with
Vivendi in 2001.
20
We expect that our North American publishing net revenues will decrease in
2003 compared to 2002, mainly due to decreased unit sales and releasing all new
titles under the terms of the August 2002 distribution agreement with Vivendi.
North American net revenues for the year ended December 31, 2001 were $35.0
million. The decrease in North American net revenues in 2001 was mainly due to
our release of only 8 titles in 2001 compared to 26 titles in 2000 resulting in
a decrease in North American sales of $21.6 million, partially offset by a
decrease in product returns and price concessions of $2.8 million as compared to
the 2000 period. The decrease in title releases across all platforms is a result
of our continued focus on product planning and the release of fewer, higher
quality titles. Our returns were a higher percentage of sales due primarily to
price concessions we granted in connection with the North American distribution
agreement we entered into with Vivendi.
International net revenues for the year ended December 31, 2002 were $5.7
million. The decrease in International net revenues for the year ended December
31, 2002 was mainly due to the reduction in title releases during the year which
resulted in a $12.2 million decrease in revenue, partially offset by a decrease
in product returns and price concessions of $2.4 million compared to the 2001
period. Our product planning efforts during 2002 also contributed to the
reduction of titles released in the International markets. Furthermore, our
returns as a percentage of revenue, continued to increase as we experienced a
high level of product returns and price concessions due to certain titles not
gaining broad market acceptance.
We expect that our International publishing net revenues will increase in
2003 as compared to 2002, mainly due to increased unit sales. However, if Virgin
Europe is not able to reorganize and liquidates, we may need to obtain a new
European distributor in a short amount of time. If we are not able to engage a
new distributor, it could have a material negative impact on our European sales.
International net revenues for the year ended December 31, 2001 were $15.5
million. The decrease in International net revenues for the year ended December
31, 2001 was mainly due to the reduction in title releases during the year which
resulted in a $17.4 million decrease in revenue and an increase in product
returns and price concessions of $1.8 million compared to the 2000 period. Our
product planning efforts during 2001 also contributed to the reduction of titles
released in the International markets. Furthermore, our returns as a percentage
of revenue, increased as we experienced a high level of product returns and
price concessions due to certain titles not gaining broad market acceptance.
OEM, royalty and licensing net revenues for the year ended December 31,
2002 were $12.1 million, an increase of $6.1 million as compared to the same
period in 2001. The OEM business decreased $1.3 million as a result of our
efforts to focus on our core business of developing and publishing video game
titles for distribution directly to the end users and our continued focus on
video game console titles, which typically are not bundled with other products.
The year ended December 31, 2002 also included revenues related to the sale of
publishing rights for one of our products and the recognition of deferred
revenue for a licensing transaction. In January 2002, we sold the publishing
rights to this title to the distributor in connection with a settlement
agreement entered into with the third party developer. The settlement agreement
provided, among other things, that we assign our rights and obligations under
the product agreement to the third party distributor. As a result, we recorded
net revenues of $5.6 million in the three months ended March 31, 2002. In
February 2002, a licensing transaction we entered into in 1999 expired and we
recognized revenue of $1.2 million, the unearned portion of the minimum
guarantee. We expect that OEM, royalty and licensing net revenues in 2003 will
increase compared to 2002 primarily related to the recording of $15 million in
revenue resulting from the sale of the Hunter video game franchise in February
2003.
OEM, royalty and licensing net revenues for the year ended December 31,
2001 were $6.0 million, a decrease of $7.1 million as compared to the same
period in 2000. The OEM business decreased $3.9 million as a result of general
market decreases in personal computer sales. The year ended December 31, 2000
also included $3 million of revenues related to a multi-product licensing
transaction with Titus Interactive S.A., our majority stockholder, which did not
recur in 2001.
Platform Net Revenues
PC net revenues for the year ended December 31, 2002 were $15.8 million, a
decrease of 55 percent compared to the same period in 2001. The decrease in PC
net revenues in 2002 was primarily due to the release of one major hit title in
21
2002 (Icewind Dale II), which was released under the new distribution agreement
with Vivendi in North America, as compared to three major hit titles released in
2001. The decrease in PC net revenues were further affected by releasing only 1
title in 2002 compared to a total of 7 titles in 2001. We expect our PC net
revenues to decrease in 2003 as compared to 2002 as we expect to release only
one to two new titles and as we continue to focus on video game console titles.
Video game console net revenues increased 3 percent for the year ended December
31, 2002 compared to the same period in 2001, due to sales generated from the
release of Hunter: The Reckoning (Xbox), and continued sales of Baldur's Gate:
Dark Alliance (PlayStation 2), which was released in 2001. Our other video game
releases in 2002 included RLH (PlayStation 2), Baldur's Gate: Dark Alliance
(Xbox), Baldur's Gate: Dark Alliance (Gamecube) and Hunter (Gamecube). Even
though we released 5 titles in 2002 as compared to 3 in 2001, net revenues did
not increase substantially mainly due to releasing titles under the new
distribution agreement with Vivendi, whereby, we record a lower per unit rate
and in return Vivendi is responsible for all manufacturing, marketing, and
distribution expenditures. We anticipate releasing four to five new titles in
2003 and expect net revenues to increase in 2003 partly due to the fact that we
anticipate releasing the sequel to the major title release Baldur's Gate: Dark
Alliance on PlayStation 2 and Xbox in the latter half of 2003.
PC net revenues for the year ended December 31, 2001 were $34.9 million, a
decrease of 53 percent compared to the same period in 2000. The decrease in PC
net revenues in 2001 was primarily due to the release of three major hit titles
in 2001 (Icewind Dale: Heart of Winter, Fallout Tactics and Baldur's Gate II:
Throne of Bhaal), as compared to seven major hit titles released in 2000. The
decrease in PC net revenues was further affected by releasing only a total of 7
titles in 2001 compared to a total of 18 titles in 2000. Video game console net
revenues increased 6 percent for the year ended December 31, 2001 compared to
the same period in 2000, due to sales generated from the release of Baldur's
Gate: Dark Alliance (PlayStation 2). Our other video game releases include MDK
2: Armageddon (PlayStation 2) and Giants (PlayStation 2). In 2001, our 3 title
releases were developed for next generation video game consoles and as a result
price points for the 2001 releases were higher than the 4 title releases in
2000.
Cost of Goods Sold; Gross Margin
Our cost of goods sold decreased 42 percent to $26.7 million in the year
ended December 31, 2002 compared to the same period in 2001. Furthermore, we
incurred $4.1 million of non-recurring charges related to the write-off of
prepaid royalties on titles that were not expected to meet our desired profit
requirements as compared to $8.1 million in the 2001 period. In addition, the
decrease was a result of distributing five titles through Vivendi under the new
distribution agreement, in which the only cost of goods element we incur is
royalty expense. Under this new agreement, Vivendi pays us a lower per unit rate
and in return is responsible for all manufacturing, marketing and distribution
expenditures. We expect our cost of goods sold to decrease in 2003 as compared
to 2002 due to the continuation of our distributing all of our new releases in
North America through this new agreement with Vivendi. Our gross margin
increased to 39 percent in 2002 from 19 percent in 2001. This was due to a
decrease in our royalty expense as a result of a decrease of $4.0 million in
write-off of prepaid royalties, a decrease in our product cost of goods and a
decrease in product returns and price concessions as compared to the 2001 period
due to distributing the majority of our new releases in North America under the
new agreement with Vivendi. We expect our gross profit margin and gross profit
to increase in 2003 as compared to 2002 mainly due to the sale of the Hunter
franchise in February 2003, and the fact that we do not expect to incur any
unusual product returns and price concessions or any write-offs of prepaid
royalties in 2003.
Our cost of goods sold decreased 15 percent to $45.8 million in the year
ended December 31, 2001 compared to the same period in 2000. Furthermore, we
incurred $8.1 million of non-recurring charges related to the write-off of
prepaid royalties on titles that we decided to cancel because these titles were
not expected to meet our desired profit requirements. Our gross margin decreased
to 19 percent for 2001 from 47 percent in 2000. This was due to an increase in
our royalty expense as a result of the $8.1 million write-off of prepaid
royalties, an increase in our product cost of goods due to our increase in video
game console title sales, which typically have a higher per unit cost, and an
increase in our product returns and price concessions as compared to 2000.
Marketing and Sales
Marketing and sales expenses primarily consist of advertising and retail
marketing support, sales commissions, marketing and sales personnel, customer
support services and other related operating expenses. Marketing and sales
expenses for the year ended December 31, 2002 were $5.8 million, a 69 percent
decrease as compared to the 2001
22
period. The decrease in marketing and sales expenses is due to a $7.9 million
reduction in advertising and retail marketing support expenditures and a
decrease of $4.5 million in personnel costs and general expenses due to fewer
product releases in 2002 and our shift from a direct sales force for North
America to a distribution arrangement with Vivendi. Also, the decrease in
marketing and sales expenses was a result of a decrease of $0.5 million in
overhead fees paid to Virgin under our April 2001 settlement with Virgin (See
Activities with Related Parties). We expect our marketing and sales expenses to
decrease in 2003 compared to 2002, due to lower personnel costs from our reduced
headcount, a reduction in overhead fees paid to Virgin pursuant to the April
2001 settlement and releasing titles under the terms of the new distribution
agreement whereby Vivendi pays us a lower per unit rate and in return assumes
all marketing expenditures.
Marketing and sales expenses for the year ended December 31, 2001 were
$18.7 million, a 20 percent decrease as compared to the 2000 period. The
decrease in marketing and sales expenses was due to a $3.9 million reduction in
advertising and retail marketing support expenditures due to fewer product
releases in 2001 and a $2.0 million decrease in personnel costs and general
expenses due in part to our shift from a direct sales force for North America to
a distribution arrangement with Vivendi. The decrease in marketing and sales
expenses was partially offset by $1.3 million in overhead fees paid to Virgin
under our April 2001 settlement with Virgin (See Activities with Related
Parties).
General and Administrative
General and administrative expenses primarily consist of administrative
personnel expenses, facilities costs, professional fees, bad debt expenses and
other related operating expenses. General and administrative expenses for the
year ended December 31, 2002 were $7.7 million, a 39 percent decrease as
compared to the same period in 2001. The decrease is due to a $4.9 million
decrease in personnel costs and general expenses. In the 2002 period, we
incurred significant charges of $0.4 million in loan termination fees associated
with the termination of our line of credit and $0.5 million in consulting
expenses payable to our investment bankers, Europlay 1, LLC, incurred to assist
us with the restructuring of the company. In the 2001 period, we incurred
significant charges of $0.7 million provision for the termination of a building
lease in the United Kingdom and $0.5 million in legal, audit and investment
banking fees and expenses incurred principally in connection with the efforts of
a proposed sale of the Company which was terminated. We expect our general and
administrative expenses to remain relatively constant in 2003 compared to 2002.
General and administrative expenses for the year ended December 31, 2001
were $12.6 million, a 23 percent increase as compared to the same period in
2000. The increase is due in part to a $0.7 million provision for the
termination of a building lease in the United Kingdom, a $0.1 million increase
in the provision for bad debt, $0.5 million in legal, accounting and investment
banking fees and expenses incurred principally in connection with efforts to
sell the company which was terminated, $0.5 million in consulting expenses
payable to Titus, incurred to assist us with the restructuring of the company
and a $0.6 million increase in personnel costs and general expenses.
Product Development
We charge internal product development expenses, which consist primarily of
personnel and support costs, to operations in the period incurred. Product
development expenses for the year ended December 31, 2002 were $16.2 million, a
21 percent decrease as compared to the same period in 2001. This decrease was
due to a $4.4 million decrease in personnel costs as a result of a reduction in
headcount and the sale of Shiny Entertainment, Inc. in April 2002. We expect our
product development expenses to increase in 2003 compared to 2002 as we plan on
releasing more internally developed titles in 2003.
Product development expenses for the year ended December 31, 2001 were
$20.6 million, a 7 percent decrease as compared to the same period in 2000. This
decrease was due to a $1.7 million decrease in expenditures associated with
resources dedicated to completing four major internally developed titles in the
2000 period, which did not recur in the 2001 period as well as a reduction in
headcount.
Sale of Shiny Entertainment, Inc.
In April 2002, we sold our former subsidiary Shiny Entertainment, Inc. to
Infogrames Entertainment, Inc. for $47.2 million. We recognized a gain of $28.8
million on this sale. See Note 3 of Notes to Consolidated Financial Statements.
23
Other Expense, Net
Other expense consists primarily of interest expense on our lines of credit
and foreign currency exchange transaction losses. Other expenses for the year
ended December 31, 2002 were $1.5 million, a 66 percent decrease as compared to
the same period in 2001. The decreases were due to a reduction in interest
expense related to lower net borrowings and a $0.9 million gain in the
settlement and termination of a building lease in the United Kingdom.
Other expenses for the year ended December 31, 2001 were $4.5 million, a 23
percent increase as compared to the same period in 2000 due to a $0.2 million
expense associated with foreign tax withholdings, $0.4 million in loan fees paid
to our former bank associated with the transition of our line of credit to a new
bank, $0.7 million in expense related to the issuance of a warrant to a former
officer in connection with his personal guarantee on our new line of credit and
a $1.8 million penalty due to a delay in the effectiveness of a registration
statement in connection with our private placement of 8,126,770 shares of Common
Stock, offset by a $1.6 million decrease in interest expense related to lower
net borrowings on our line of credit and a $0.7 million decrease in losses
associated with foreign currency exchanges.
Provision (Benefit) for Income Taxes
We recorded a tax benefit of $0.2 million for the year ended December 31,
2002, compared with a tax provision of $0.5 million for the year ended December
31, 2001. In June 2002, the Internal Revenue Service concluded their examination
of our consolidated federal income tax returns for the years ended April 30,
1992 through 1997. In fiscal 2001, we established a reserve of $500,000,
representing management's best estimate of amounts to be paid in settlement of
the IRS claims. With the executed settlement, the actual amount owed was only
$275,000, accordingly, we adjusted our reserve and, as a result, recognized an
income tax benefit of $225,000. We have a deferred tax asset of approximately
$54 million that has been fully reserved at December 31, 2002. This tax asset
would reduce future provisions for income taxes and related tax liabilities when
realized, subject to limitations.
LIQUIDITY AND CAPITAL RESOURCES
We have funded our operations to date primarily through the use of lines of
credit, royalty and distribution fee advances, cash generated by the private
sale of securities, proceeds of our initial public offering, the sale of assets
and from results of operations. Since October 2001, we have been operating
without a line of credit, which has materially and adversely affected our
ability to finance our ongoing operations.
As of December 31, 2002, we had a working capital deficit of $17.1 million,
and our cash balance was approximately $134,000. We anticipate our current cash
reserves, proceeds from the sale of the Hunter franchise, plus our expected
generation of cash from existing operations, will only be sufficient to fund our
anticipated expenditures into the second quarter of fiscal 2003. Consequently,
we expect that we will need to substantially reduce our working capital needs
and/or raise additional financing. Along these lines, we have entered into a new
distribution agreement with Vivendi, which accelerates cash collections through
non-refundable minimum guarantees. If we do not receive sufficient financing we
may (i) liquidate assets, (ii) sell the company (iii) seek protection from our
creditors, and/or (iv) continue operations, but incur material harm to our
business, operations or financial conditions.
Our primary capital needs have historically been to fund working capital
requirements necessary to fund our net losses, the development and introduction
of products and related technologies and the acquisition or lease of equipment
and other assets used in the product development process. Our operating
activities used cash of $28.2 million during the year ended December 31, 2002,
primarily attributable to payments for accounts payable and royalty liabilities,
recoupment of advances received by distributors, and refund of advances received
from Vivendi and a console hardware manufacturer for the development of titles
for its console platform in connection with the sale of Shiny. These uses of
cash in operating activities were partially offset by collections of accounts
receivable and accounts receivable from related parties and reductions of
inventory.
Net cash used by financing activities of $4.7 million for the year ended
December 31, 2002, consisted primarily of repayments of our working capital line
of credit and repayments to our former Chairman. Cash provided by investing
activities of $32.9 million for the year ended December 31, 2002 consisted of
proceeds from the sale of Shiny, offset by
24
normal capital expenditures, primarily for office and computer equipment used in
our operations. We do not currently have any material commitments with respect
to any future capital expenditures.
The following summarizes our contractual obligations under non-cancelable
operating leases and other borrowings at December 31, 2002, and the effect such
obligations are expected to have on our liquidity and cash flow in future
periods.
Less Than 1 - 3 After
December 31, 2002 Total 1 Year Years 3 Years
--------- --------- ------- --------
(In thousands)
Contractual cash obligations -
Non-cancelable operating
lease obligations $ 5,215 $ 1,386 $ 3,065 $ 764
========= ========= ======= ========
In April 2002, we entered into a settlement agreement with the landlord of
an office facility in the United Kingdom, whereby we returned the property back
to the landlord and were released from any further lease obligations. This
settlement reduced our total contractual cash obligations by $1.3 million
through fiscal 2005.
Our main source of capital is from the release of new titles. Historically,
we have had some delays in the release of new titles and we anticipate that we
may continue to incur delays in the release of future titles. These delays can
have a negative impact on our short-term liquidity, but should not affect our
overall liquidity.
To reduce our working capital needs, we have implemented various measures
including a reduction of personnel, a reduction of fixed overhead commitments,
cancellation or suspension of development on future titles which management
believes do not meet sufficient projected profit margins, and the scaling back
of certain marketing programs associated with the cancelled projects. Management
will continue to pursue various alternatives to improve future operating results
and further expense reductions, some of which may have a long-term adverse
impact on our ability to generate successful future business activities. In
addition, we continue to seek external sources of funding, including but not
limited to, a sale or merger of the company, a private placement of our capital
stock, the sale of selected assets, the licensing of certain product rights in
selected territories, selected distribution agreements, and/or other strategic
transactions sufficient to provide short-term funding, and potentially achieve
our long-term strategic objectives. In this regard, we completed the sale of
Shiny in April 2002, for approximately $47.2 million. Additionally, in August
2002, our Board of Directors established a Special Committee comprised of
directors that are independent of our largest stockholder, Titus Interactive
S.A., to investigate strategic options, including raising capital from the sale
of debt or equity securities and a sale of the company.
In order to improve our cash flow, in August 2002, we entered into a new
distribution arrangement with Vivendi, whereby, Vivendi will distribute
substantially all of our products in North America for a period of three years
as a whole and two years with respect to each product providing for a potential
maximum term of five years. Under the August 2002 agreement, Vivendi will pay us
sales proceeds less amounts for distribution fees, price concessions and
returns. Vivendi is responsible for all manufacturing, marketing and
distribution expenditures, and bears all credit, price concessions and inventory
risk, including product returns. Upon our delivery of a gold master to Vivendi,
Vivendi will pay us, as a non-refundable minimum guarantee, a specified percent
of the projected amount due to us based on projected initial shipment sales,
which are established by Vivendi in accordance with the terms of the agreement.
The remaining amounts are due upon shipment of the titles to Vivendi's
customers. Payments for future sales that exceed the projected initial shipment
sales are paid on a monthly basis. We expect this new arrangement to improve our
short-term liquidity, but should not impact our overall liquidity.
If operating revenues from product releases are not sufficient to fund our
operations, no assurance can be given that alternative sources of funding could
be obtained on acceptable terms, or at all. These conditions, combined with our
historical operating losses and deficits in stockholders' equity and working
capital, raise substantial doubt about our ability to continue as a going
concern. The accompanying consolidated financial statements do not include any
adjustments to reflect the possible future effects on the recoverability and
classification of assets and liabilities that may result from the outcome of
this uncertainty.
25
ACTIVITIES WITH RELATED PARTIES
Our operations involve significant transactions with Titus, our majority
stockholder, Virgin, a wholly-owned subsidiary of Titus, and Vivendi, an owner
of 5 percent of our common stock. In addition, we obtained financing from the
former Chairman of the company.
Transactions with Titus
In March 2002, Titus converted its remaining 383,354 shares of Series A
preferred stock into approximately 47.5 million shares of our common stock.
Titus now owns approximately 67 million shares of common stock, which represents
approximately 71 percent of our outstanding common stock, our only voting
security, immediately following the conversion.
Titus retained Europlay as consultants to assist with the restructuring of
the company. This arrangement with Europlay is with Titus, however, we agreed to
reimburse Titus for consulting expenses incurred on our behalf. In connection
with the sale of Shiny, we agreed to pay Europlay directly for their services
with the proceeds received from the sale, which Europlay received. We have also
entered into a commission-based agreement with Europlay where Europlay will
assist us with strategic transactions, such as debt or equity financing, the
sale of assets or an acquisition of the company. Under this arrangement,
Europlay assisted us with the sale of Shiny.
In connection with the equity investments by Titus, we perform distribution
services on behalf of Titus for a fee. In connection with such distribution
services, we recognized fee income of $22,000, $21,000 and $435,000 for the
years ended December 31, 2002, 2001 and 2000, respectively.
In March 2003, we entered into a note receivable with Titus Software Corp.,
or "TSC", a subsidiary of Titus, for $226,000. The note earns interest at 8
percent per annum and is due in February 2004. The note is secured by (i) 4
million shares of our common stock held by Titus (ii) TSC's rights in and to a
note receivable due from the President of Interplay and (iii) rights in and to
TSC's most current video game title releases during 2003 and 2004.
In March 2003, our Board of Directors further authorized an additional
$500,000 loan to Titus, with interest at 8 percent per annum and a maturity date
in February 2004, on the condition that Titus is able to provide sufficient
security that is acceptable to the Board, which shall include, without
limitation, 9.3 million shares of our common stock held by Titus and (ii) rights
in and to Titus' most current video game title releases during 2003 and 2004.
In April 2002, we entered into an agreement with Titus, pursuant to which,
among other things, we sold to Titus all right, title and interest in the games
"EarthWorm Jim", "Messiah", "Wild 9", "R/C Stunt Copter", "Sacrifice", "MDK",
"MDK II", and "Kingpin", and Titus licensed from us the right to develop,
publish, manufacture and distribute the games "Hunter I", "Hunter II", "Icewind
Dale I", "Icewind Dale II", and "BG: Dark Alliance II" solely on Nintendo
Advance GameBoy game system for the life of the games. As consideration for
these rights, Titus issued to us a promissory note in the principal amount of
$3.5 million, which note bears interest at 6 percent per annum. The promissory
note was due on August 31, 2002, and may be paid, at Titus' option, in cash or
in shares of Titus common stock with a per share value equal to 90 percent of
the average trading price of Titus' common stock over the 5 days immediately
preceding the payment date. Pursuant to our April 26, 2002 agreement with Titus,
on or before July 25, 2002, we had the right to solicit offers from and
negotiate with third parties to sell the rights and licenses granted under the
April 26, 2002 agreement. If we had entered into a binding agreement with a
third party to sell these rights and licenses for an amount in excess $3.5
million, we would have rescinded the April 26, 2002 agreement with Titus and
recovered all rights granted and released Titus from all obligations thereunder.
The Company's efforts to enter into a binding agreement with a third party were
unsuccessful. Moreover, we have provided Titus with a guarantee under this
agreement, which provides that in the event Titus does not achieve gross sales
of at least $3.5 million by June 25, 2003, and the shortfall is not the result
of Titus' failure to use best commercial efforts, we will pay to Titus the
difference between $3.5 million and the actual gross sales achieved by Titus,
not to exceed $2 million. We are in the later stages of negotiations with Titus
to repurchase t