Attached files

file filename
EX-31.1 - SouthPeak Interactive CORPv165467_ex31-1.htm
EX-32.1 - SouthPeak Interactive CORPv165467_ex32-1.htm
EX-31.2 - SouthPeak Interactive CORPv165467_ex31-2.htm
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 

Form 10-Q
 
     
(Mark One)
   
     
þ
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the Quarterly Period Ended September 30, 2009
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the Transition Period from          to          
 
Commission File Number 000-51869
 
SouthPeak Interactive Corporation
(Exact Name of Registrant as Specified in Its Charter)
 
Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
20-3290391
(I.R.S. Employer
Identification No.)
 
2900 Polo Parkway
Midlothian, Virginia 23113
(804) 378-5100
(Address including zip code, and telephone number,
including area code, of principal executive offices)
 
Not applicable
(Former name, former address and former fiscal year, if changed since last report)
 
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 þ     No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
 
Yes ¨     No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o
Accelerated filer o
Non-accelerated filer o
Smaller reporting company þ
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
Yes o     No þ
 
As of November 6, 2009, 44,998,600 shares of common stock, par value $0.0001 per share, of the registrant were outstanding.

 
 

 

TABLE OF CONTENTS
 
     
Page
 
           
 
PART I — FINANCIAL INFORMATION
       
Item 1.  
Financial Statements
    2  
     
Condensed Consolidated Financial Statements (unaudited)
    2  
     
Condensed Consolidated Balance Sheets as of September 30, 2009 and June 30, 2009 (unaudited)
    2  
     
Condensed Consolidated Statements of Operations for the three months ended September 30, 2009 and 2008 (unaudited)
    3  
 
Condensed Consolidated Statements of Cash Flows for the three months ended September 30, 2009 and 2008 (unaudited)
    4  
     
Notes to Condensed Consolidated Financial Statements
    5  
Item 2.  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    23  
Item 3.  
Quantitative and Qualitative Disclosures about Market Risk
    31  
Item 4T.  
Controls and Procedures
     31  
           
 
PART II — OTHER INFORMATION
       
           
Item 1.  
Legal Proceedings
    33  
Item 1A.  
Risk Factors
    33  
Item 6.  
Exhibits
    33  
           
SIGNATURES
       
 
 
1

 

PART I

Item 1.  Condensed Consolidated Financial Statements
 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
 

   
September 30, 2009
   
June 30, 2009
 
   
(Unaudited)
       
Assets 
           
             
Current assets:
           
Cash and cash equivalents
 
$
273,481
   
$
648,311
 
Restricted cash
   
827,665
     
1,245,582
 
Accounts receivable, net of allowances of $8,135,879 and $7,214,984 at September 30, 2009 and June 30, 2009, respectively
   
12,482,104
     
4,872,767
 
Inventories
   
7,996,651
     
4,459,837
 
Current portion of advances on royalties
   
5,823,254
     
8,435,415
 
Current portion of intellectual property licenses
   
387,475
     
410,995
 
Related party receivables
   
72,032
     
33,207
 
Prepaid expenses and other current assets
   
536,764
     
672,795
 
                 
Total current assets
   
28,399,426
     
20,788,909
 
                 
Property and equipment, net
   
2,728,130
     
2,754,139
 
Advances on royalties, net of current portion
   
1,556,798
     
1,556,820
 
Intellectual property licenses, net of current portion
   
1,821,964
     
1,917,858
 
Goodwill
   
8,031,276
     
7,490,065
 
Intangible assets, net
   
27,025
     
43,810
 
Other assets
   
11,762
     
11,872
 
                 
Total assets
 
$
42,576,381
   
$
34,553,473
 
                 
Liabilities and Shareholders’ Equity
               
                 
Current liabilities:
               
Line of credit
 
$
7,123,865
   
$
5,349,953
 
Current maturities of long-term debt
   
51,697
     
50,855
 
Production advance payable
   
3,755,104
     
-
 
Accounts payable
   
18,942,329
     
19,686,168
 
Accrued royalties
   
1,321,128
     
414,696
 
Accrued expenses and other current liabilities
   
4,297,063
     
2,419,100
 
Deferred revenues
   
2,842,712
     
2,842,640
 
Due to shareholders
   
-
     
232,440
 
Due to related parties
   
2,200
     
125,045
 
Accrued expenses - related parties
   
79,491
     
184,766
 
Total current liabilities
   
38,415,589
     
31,305,663
 
                 
Long-term debt, net of current maturities
   
1,526,261
     
1,538,956
 
Total liabilities
   
39,941,850
     
32,844,619
 
                 
Commitments and contingencies
   
-
     
-
 
                 
Shareholders’ equity:
               
                 
Preferred stock, $0.0001 par value; 5,000,000 shares authorized; no shares issued and outstanding at September 30, 2009 and June 30, 2009
   
-
     
-
 
Series A convertible preferred stock, $0.0001 par value; 15,000,000 shares authorized; 5,653,833 and 5,953,833 shares issued and outstanding at September 30, 2009 and June 30, 2009, respectively; aggregate liquidation preference of $5,653,833 at September 30, 2009
   
565
     
595
 
Common stock, $0.0001 par value; 90,000,000 shares authorized; 44,921,600 and 44,530,100 shares issued and outstanding at September 30, 2009 and June 30, 2009, respectively
   
4,492
     
4,453
 
Additional paid-in capital
   
25,367,113
     
25,210,926
 
Accumulated deficit
   
(22,458,819
)
   
(23,145,800
)
Accumulated other comprehensive loss
   
(278,820
)
   
(361,320
                 
Total shareholders’ equity
   
2,634,531
     
1,708,854
 
Total liabilities and shareholders’ equity
 
$
42,576,381
   
$
34,553,473
 
 
See notes to condensed consolidated financial statements.

 
2

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 
   
For the three months ended
September 30,
 
   
2009
   
2008
 
             
Net revenues
 
$
16,709,649
   
$
8,387,703
 
                 
Cost of goods sold:
               
Product costs
   
3,546,686
     
5,425,553
 
Royalties
   
5,000,671
     
808,921
 
Intellectual property licenses
   
119,660
     
43,980
 
                 
Total cost of goods sold
   
8,667,017
     
6,278,454
 
                 
Gross profit
   
8,042,632
     
2,109,249
 
                 
Operating expenses: 
               
Warehousing and distribution
   
286,511
     
207,583
 
Sales and marketing
   
3,655,056
     
1,995,736
 
Transaction costs
   
-
     
18,380
 
General and administrative
   
3,114,768
     
1,380,425
 
                 
Total operating expenses
   
7,056,335
     
3,602,124
 
                 
Income (loss) from operations
   
986,297
     
(1,492,875
)
                 
Interest expense, net
   
299,316
     
58,879
 
                 
Net income (loss)
   
686,981
     
(1,551,754
)
                 
Deemed dividend related to beneficial conversion feature on Series A convertible preferred stock
   
-
     
1,142,439
 
                 
Net income (loss) attributable to common shareholders
 
$
686,981
   
$
(2,694,193
)
                 
Basic income (loss) per share: 
 
$
0.02
   
$
(0.08
)
Diluted income (loss) per share: 
 
$
0.01
   
$
(0.08
)
                 
Weighted average number of common shares outstanding - Basic
   
44,821,051
     
35,920,100
 
Weighted average number of common shares outstanding - Diluted
   
50,649,103
     
35,920,100
 
 
See notes to condensed consolidated financial statements.

 
3

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
  
 
For the three months ended
September 30,
 
   
2009
   
2008
 
Cash flows from operating activities:
           
Net income (loss)
 
$
686,981
   
$
(1,551,754
Adjustments to reconcile net cash used in operating activities:
               
Depreciation and amortization
   
64,877
     
36,209
 
Allowances for price protection, returns, and defective merchandise
   
958,427
     
(48,374
)
Bad debt expense
   
(37,531
   
-
 
Stock-based compensation expense
   
156,196
     
164,362
 
Amortization of royalties and intellectual property licenses
   
4,215,050
     
852,901
 
Loss on disposal of fixed assets
   
4,839
     
-
 
                 
Changes in operating assets and liabilities:
               
Accounts receivable
   
(8,530,233
)
   
4,552,796
 
Inventories
   
(3,536,814
)
   
2,149,302
 
Advances on royalties
   
(1,449,716
)
   
(2,602,434
)
Intellectual property licenses
   
-
     
(440,000
)
Related party receivables
   
(38,825
)
   
11,247
 
Prepaid expenses and other current assets
   
136,031
     
(2,094,164
)
Accounts payable
   
(688,416
   
(1,965,641
)
Production advance payable
   
3,755,104
     
-
 
Accrued royalties
   
906,432
     
(273,013
)
Accrued expenses - related parties
   
(105,275
)
   
41,521
 
Accrued expenses and other current liabilities
   
1,281,329
     
(659,048
                 
Total adjustments
   
(2,908,525
   
(274,336
                 
Net cash used in operating activities
   
(2,221,544
)
   
(1,826,090
)
                 
Cash flows from investing activities:
               
Purchases of property and equipment
   
(26,734
)
   
(185,747
)
Change in restricted cash
   
417,917
     
65,314
 
Net cash provided by (used in) investing activities
   
391,183
     
(120,433
)
                 
Cash flows from financing activities:
               
Proceeds from line of credit
   
8,117,146
     
5,880,000
 
Repayments of line of credit
   
(6,343,234
)
   
(8,044,191
)
Repayments of long-term debt
   
(11,853
)
   
(6,163
)
Net proceeds from (repayments of) amounts due to shareholders
   
(232,440
   
(228,998
)
Net proceeds from (repayments of) amounts due to related parties
   
(122,845
   
41,599
 
Proceeds from the issuance of Series A convertible preferred stock, net of cash offering costs
   
-
     
1,361,281
 
                 
Net cash provided by (used in) financing activities
   
1,406,774
     
(996,472
)
                 
Effect of exchange rate changes on cash and cash equivalents
   
48,757
     
11,607
 
                 
Net decrease in cash and cash equivalents
   
(374,830
)
   
(2,931,388
)
Cash and cash equivalents at beginning of the period
   
648,311
     
4,095,036
 
                 
Cash and cash equivalents at end of the period
 
$
273,481
   
$
1,163,648
 
                 
Supplemental cash flow information:
               
Cash paid during the period for interest
 
$
99,261
   
$
57,657
 
Cash paid during the period for taxes
 
$
-
   
$
2,457
 
                 
Supplemental disclosure of non-cash activities:
               
Intellectual property licenses included in accrued expenses and other current liabilities
 
$
-
   
$
110,000
 
Contingent purchase price payment obligation related to Gamecock acquisition
 
$
596,634
   
$
-
 
 
See notes to condensed consolidated financial statements.

 
4

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Summary of Significant Accounting Policies
 
Business
 
SouthPeak Interactive Corporation ( the “Company”) is an independent developer and publisher of interactive entertainment software.  The Company develops, markets and publishes videogames for all leading gaming and entertainment hardware platforms, including home videogame consoles such as Microsoft Corporation’s (“Microsoft”) Xbox 360 (“Xbox360”), Nintendo Co. Ltd.’s (“Nintendo”) Wii (“Wii”), Sony Computer Entertainment’s (“Sony”) PlayStation 3 (“PS3”) and PlayStation 2 (“PS2”); handheld platforms such as Nintendo Dual Screen (“DS”), Nintendo DSi, Sony PlayStation Portable (“PSP”), Sony PSPgo, Apple Inc. (“Apple”) iPhone; and personal computers.  The Company’s titles span a wide range of categories and target a variety of consumer demographics, ranging from casual players to hardcore gaming enthusiasts.
 
The Company maintains its operations in the United States and the United Kingdom. The Company sells its games to retailers and distributors in North America and United Kingdom, and primarily to distributors in the rest of Europe, Australia and Asia.
 
The Company has one operating segment, a publisher and distributor of interactive entertainment software for home video consoles, handheld platforms and personal computers.  To date, management has not considered discrete geographical or other information to be relevant for purposes of making decisions about allocations of resources.
 
Gamecock Acquisition
 
On October 10, 2008, the Company acquired Gone Off Deep, LLC, doing business as Gamecock Media Group (“Gamecock”), pursuant to a definitive purchase agreement.  Gamecock’s operations were included in the Company’s financial statements for all periods subsequent to the consummation of the business combination only.
 
Liquidity Risk
 
For the fiscal year ended June 30, 2009, the Company incurred a significant loss.  In order to meet its working capital needs during the past fiscal year as well as currently, the Company has been, and is, dependent on its line of credit with SunTrust Banks, Inc. (“SunTrust”).  This line of credit is scheduled to expire on November 30, 2009.  The line of credit has been in place since 2005 and has been extended every year thereafter. Management is currently in discussions with SunTrust to renew the line of credit.  While management believes the line of credit will be renewed, there are no assurances that the line of credit will be renewed or renewed at terms that are acceptable to the Company.  In the event the line of credit is not renewed, management plans to pursue other financing sources which, based upon the quality of the Company’s receivables, management believes will be available to the Company.  The Company’s largest shareholder who serves as the Company’s chairman, has committed to fund operating cash shortfalls in the absence of another source of financing.   In addition, independent of the risks associated with the non-renewal of the SunTrust line of credit, the Company has engaged an investment bank for the purpose of potentially raising capital to fund its growth most likely through the sale of equity securities during its fiscal year ended June 30, 2010.  However, such capital, if needed and available, may not have terms favorable to the Company or its current shareholders.
 
The Company’s business model allows it to scale certain of its costs in reference to its available capital and market conditions, including funding new game development costs as well as certain operating expenses, such as sales and marketing costs.  Irrespective of having a credit facility or other funding in place, management closely monitors the retail/consumer landscape, especially for upcoming holiday seasons, and reevaluates its sales and revenue forecasts in order to scale its expenses and game development costs to the Company’s performance and its available capital.  Based on the Company’s projected operating plan, the Company believes that it has access to adequate financial resources to fund its operations for at least the next twelve months.
 
Basis of Presentation
 
The accompanying unaudited condensed consolidated financial statements as of September 30, 2009 and for the three month periods ended September 30, 2009 and 2008 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial reporting. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. In the opinion of management, all adjustments (all of which are of a normal, recurring nature) considered for a fair presentation have been included. Operating results for the three months ended September 30, 2009 are not necessarily indicative of the results that may be expected for the year ending June 30, 2010.

 
5

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Summary of Significant Accounting Policies, continued
 
The accounting policies followed by the Company with respect to unaudited interim financial statements are consistent with those stated in the Company’s annual report on Form 10-K. The accompanying June 30, 2009 financial statements were derived from the Company’s audited financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s annual report on Form 10-K for the year ended June 30, 2009 filed with the SEC.
 
The accompanying unaudited condensed consolidated financial statements include the accounts of SouthPeak Interactive Corporation, and its wholly-owned subsidiaries SouthPeak Interactive, L.L.C., SouthPeak Interactive, Ltd., Vid Sub, LLC, Gone Off Deep, LLC, and Gamecock Media Europe Ltd. All intercompany accounts and transactions have been eliminated in consolidation.
 
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of net revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to the recoverability of advances on royalties, intellectual property licenses and intangibles, valuation of inventories, realization of deferred income taxes, the adequacy of allowances for sales returns, price protection and doubtful accounts, accrued liabilities, the valuation of stock-based transactions and assumptions used in the Company’s goodwill impairment test.  These estimates generally involve complex issues and require the Company to make judgments, involve analysis of historical and the prediction of future trends, and are subject to change from period to period. Actual amounts could differ significantly from these estimates.
 
Subsequent events have been evaluated through the filing date (November 10, 2009) of these unaudited condensed consolidated financial statements.
 
Concentrations of Credit Risk, Major Customers and Major Vendors
 
The financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash balances with financial institutions and accounts receivable. The Company maintains cash in bank accounts that, at times, may exceed federally insured limits.  The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.
 
The Company does not generally require collateral or other security to support accounts receivable. Management must make estimates of the uncollectibility of the accounts receivable. The Company considers accounts receivable past due based on how recently payments have been received. The Company has established an allowance for doubtful accounts based upon the facts surrounding the credit risk of specific customers, past collections history and other factors.
 
The Company has three customers, Wal-Mart, GameStop, and Topware Entertainment, which accounted for 20%, 15%, and 10%, respectively, of consolidated gross revenues for the three months ended September 30, 2009.  Wal-Mart, GameStop, Navarre Corporation, and PDQ Distribution Limited accounted for 18%, 17%, 10%, and 10%, respectively, of consolidated gross accounts receivable at September 30, 2009.  For the three months ended September 30, 2008, Wal-Mart, GameStop, and Circuit City accounted for 20%, 14%, and 10%, respectively, of consolidated gross revenues.  Navarre Corporation, GameStop, and Wal-Mart accounted for 20%, 17% and 15%, respectively, of consolidated gross accounts receivable at June 30, 2009.  
 
The Company publishes videogames for the proprietary console and hand-held platforms created by Microsoft, Sony and Nintendo, pursuant to the licenses they have granted to the Company. Should the Company’s licenses with any of such three platform developers not be renewed by the developer, it would cause a disruption in the Company’s operations. The Company expects that such contracts will be renewed in the normal course of business.

 
6

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Summary of Significant Accounting Policies, continued
 
Amounts incurred related to these three vendors as of September 30, 2009 and June 30, 2009 and for the three month periods ended September 30, 2009 and 2008 are as follows:
 
   
Cost of Goods Sold — Products
   
Accounts Payable
 
   
For the three months
ended September 30,
2009
   
For the three months
ended September 30,
2008
   
As of September 30,
2009
   
As of June 30,
2009
 
                         
Microsoft
 
$
2,737,842
   
$
191,149
   
$
1,219,934
   
$
142,329
 
Nintendo
 
$
831,796
   
$
825,303
   
$
-
   
$
-
 
Sony
 
$
27,522
   
$
390,306
   
$
17,423
   
$
12,493
 
 
In addition, the Company has purchased a significant amount of videogames for resale for such platforms from a single supplier. Such purchases amounted to $-0- and $1,536,499 in “cost of goods sold - product costs” for the three months ended September 30, 2009 and 2008, respectively. Amounts included in accounts payable for this vendor at September 30, 2009 and June 30, 2009 totaled $5,625,377 and $8,652,019, respectively.
 
Restricted Cash
 
Restricted cash relates to deposits held as cash collateral for the line of credit and funds held in escrow pending resolution of an outstanding litigation matter.
 
At September 30, 2009 and June 30, 2009, restricted cash consisted of the following:
 
   
September 30,
2009
   
June 30,
2009
 
Cash collateral for the line of credit (See Note 5)
 
$
-
   
$
742,199
 
Funds held in escrow pending resolution of litigation (See Note 10), of which $22,134 and $265,919 is included as a liability at September 30, 2009 and June 30, 2009, respectively
   
827,665
     
503,383
 
Total
 
$
827,665
   
$
1,245,582
 

 
Allowances for Returns, Price Protection, and Doubtful Accounts
 
Management closely monitors and analyzes the historical performance of the Company’s various games, the performance of games released by other publishers, and the anticipated timing of other releases in order to assess future demands of current and upcoming games. Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets, but at the same time are controlled to prevent excess inventory in the channel.
 
The Company may permit product returns from, or grant price protection to, its customers under certain conditions. Price protection refers to the circumstances when the Company elects to decrease the wholesale price of a product based on the number of products in the retail channel and, when granted and taken, allows customers a credit against amounts owed by such customers to the Company with respect to open and/or future invoices. The criteria the Company’s customers must meet to be granted the right to return products or price protection include, among other things, compliance with applicable payment terms, and consistent delivery to the Company of inventory and sell-through reports. In making the decision to grant price protection to customers, the Company also considers other factors, including the facilitation of slow-moving inventory and other market factors.

 
7

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Summary of Significant Accounting Policies, continued
 
Management must estimate the amount of potential future product returns and price protection related to current period revenues utilizing industry and historical Company experience, information regarding inventory levels, and the demand and acceptance of the Company’s games by end consumers. The following factors are used to estimate the amount of future returns and price protection for a particular game: historical performance of games in similar genres; historical performance of the hardware platform; sales force and retail customer feedback; industry pricing; weeks of on-hand retail channel inventory; absolute quantity of on-hand retail channel inventory; the game’s recent sell-through history (if available); marketing trade programs; and competing games. Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price protection in any accounting period. Based upon historical experience, management believes the estimates are reasonable. However, actual returns and price protection could vary materially from management’s allowance estimates due to a number of unpredictable reasons including, among others, a lack of consumer acceptance of a game, the release in the same period of a similarly themed game by a competitor, or technological obsolescence due to the emergence of new hardware platforms. Material differences may result in the amount and timing of the Company’s revenues for any period if factors or market conditions change or if management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection.
 
Similarly, management must make estimates of the uncollectibility of the Company’s accounts receivable. In estimating the allowance for doubtful accounts, the Company analyzes the age of current outstanding account balances, historical bad debts, customer concentrations, customer creditworthiness, current economic trends, and changes in the Company’s customers’ payment terms and their economic condition. Any significant changes in any of these criteria would affect management’s estimates in establishing the allowance for doubtful accounts.
 
At September 30, 2009 and June 30, 2009, accounts receivable allowances consisted of the following:
 
   
September 30,
2009
   
June 30,
2009
 
Sales returns
 
$
1,726,231
   
$
1,294,082
 
Price protection
   
5,489,113
     
4,998,622
 
Doubtful accounts
   
848,866
     
874,645
 
Defective items
   
71,669
     
47,635
 
                 
Total allowances
 
$
8,135,879
   
$
7,214,984
 
 
Inventories
 
Inventories are stated at the lower of average cost or market. Management regularly reviews inventory quantities on hand and in the retail channel and records a provision for excess or obsolete inventory based on the future expected demand for the Company’s games. Significant changes in demand for the Company’s games would impact management’s estimates in establishing the inventory provision.  Inventory costs include licensing fees paid to platform proprietors. These licensing fees include the cost to manufacture the game cartridges. These licensing fees included in “cost of goods sold - product costs” amounted to $3,597,160 and $1,406,758 for the three months ended September 30, 2009 and 2008, respectively. Licensing fees included in inventory at September 30, 2009 and June 30, 2009 totaled $1,352,806 and $920,747, respectively.
 
Advances on Royalties 
 
The Company utilizes independent software developers to develop its games in exchange for payments to the developers based upon certain contract milestones. The Company enters into contracts with the developers once the game design has been approved by the platform proprietors and is technologically feasible.  Accordingly, the Company capitalizes such payments to the developers during development of the games. These payments are considered non-refundable royalty advances and are applied against the royalty obligations owed to the developer from future sales of the game. Any pre-release milestone payments that are not prepayments against future royalties are expensed to “cost of goods sold - royalties” in the period when the game is released. Capitalized royalty costs for those games that are cancelled or abandoned are charged to “cost of goods sold - royalties” in the period of cancellation.  Capitalized costs for games that are cancelled or abandoned prior to product release are charged to “cost of goods sold - royalties” in the period of cancellation. There were no costs for games cancelled or abandoned during the three months ended September 30, 2009 and 2008, respectively.

 
8

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Summary of Significant Accounting Policies, continued
 
Beginning upon the related games release, capitalized royalty costs are amortized to “cost of goods sold – royalties” based on the ratio of current revenues to total projected revenues for the specific game, generally resulting in an amortization period of twelve months or less.
 
The Company evaluates the future recoverability of capitalized royalty costs on a quarterly basis. For games that have been released in prior periods, the primary evaluation criterion is actual title performance. For games that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific game to which the royalties relate. Criteria used to evaluate expected game performance include: historical performance of comparable games developed with comparable technology; orders for the game prior to its release; and, for any game sequel, estimated performance based on the performance of the game on which the sequel is based.
 
Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized royalty costs. In evaluating the recoverability of capitalized royalty costs, the assessment of expected game performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual game sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors. 
 
Intellectual Property Licenses
 
Intellectual property license costs consist of fees paid by the Company to license the use of trademarks, copyrights, and software used in the development of games. Depending on the agreement, the Company may use acquired intellectual property in multiple games over multiple years or for a single game.  When no significant performance remains with the licensor upon execution of the license agreement, the Company records an asset and a liability at the contractual amount. The Company believes that the contractual amount represents the fair value of the liability. When significant performance remains with the licensor, the Company records the payments as an asset when paid and as a liability when incurred, rather than upon execution of the agreement. The Company classifies these obligations as current liabilities to the extent they are contractually due within the next twelve months.  Capitalized intellectual property license costs for those games that are cancelled or abandoned are charged to “cost of goods sold - intellectual property licenses” in the period of cancellation. There were no costs for games cancelled or abandoned during the three months ended September 30, 2009 and 2008, respectively.
 
Beginning upon the related game’s release, capitalized intellectual property license costs are amortized to “cost of sales - intellectual property licenses” based on the greater of (1) the ratio of current revenues for the specific game to total projected revenues for all games in which the licensed property will be utilized or (2) the straight-line amortization method over the estimated useful lives of the licenses. As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year.
 
The Company evaluates the future recoverability of capitalized intellectual property license costs on a quarterly basis. For games that have been released in prior periods, the primary evaluation criterion is actual title performance. For games that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific games to which the costs relate or in which the licensed trademark or copyright is to be used. Criteria used to evaluate expected game performance include: historical performance of comparable games developed with comparable technology; orders for the game prior to its release; and, for any game sequel, estimated performance based on the performance of the game on which the sequel is based.  Further, as intellectual property licenses may extend for multiple games over multiple years, the Company also assesses the recoverability of capitalized intellectual property license costs based on certain qualitative factors, such as the success of other products and/or entertainment vehicles utilizing the intellectual property and the continued promotion and exploitation of the intellectual property.

 
9

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Summary of Significant Accounting Policies, continued
 
Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized intellectual property license costs. In evaluating the recoverability of capitalized intellectual property license costs, the assessment of expected game performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual game sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.
 
Goodwill and Intangible Assets
 
Goodwill is the excess of purchase price paid over identified intangible and tangible net assets of Gamecock. Intangible assets consist of acquired game sequel titles, distribution and non-compete agreements. Certain intangible assets acquired in a business combination are recognized as assets apart from goodwill. Identified intangibles other than goodwill are generally amortized using the straight-line method over the period of expected benefit ranging from one to three years, except for acquired game sequel titles, which is a usage-based intangible asset that is amortized using the shorter of the useful life or expected revenue stream. 
 
Assessment of Impairment of Assets
 
Current accounting standards require that the Company assess the recoverability of purchased intangible assets and other long-lived assets whenever events or changes in circumstances indicate the remaining value of the assets recorded on its consolidated balance sheets is potentially impaired. In order to determine if a potential impairment has occurred, management must make various assumptions about the estimated fair value of the asset by evaluating future business prospects and estimated cash flows. For some assets, the Company’s estimated fair value is dependent upon predicting which of its products will be successful. This success is dependent upon several factors, which are beyond the Company’s control, such as which operating platforms will be successful in the marketplace, market acceptance of the Company’s products and competing products. Also, the Company’s revenues and earnings are dependent on the Company’s ability to meet its product release schedules.
 
Income Taxes
 
Income taxes are accounted for under the asset and liability method.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established to reduce deferred tax assets to the amounts expected to be realized.
 
Revenue Recognition
 
The Company recognizes revenue from the sale of videogames upon the transfer of title and risk of loss to the customer. Accordingly, the Company recognizes revenue for software titles when (1) there is persuasive evidence that an arrangement with the customer exists, which is generally a purchase order, (2) the product is delivered, (3) the selling price is fixed or determinable and (4) collection of the customer receivable is deemed probable.  The Company’s payment arrangements with customers typically provides for net 30 and 60 day terms. Advances received for licensing and exclusivity arrangements are reported on the consolidated balance sheets as deferred revenues until the Company meets its performance obligations, at which point the revenues are recognized. Revenue is recognized after deducting estimated reserves for returns, price protection and other allowances. In circumstances when the Company does not have a reliable basis to estimate returns and price protection or is unable to determine that collection of a receivable is probable, the Company defers the revenue until such time as it can reliably estimate any related returns and allowances and determine that collection of the receivable is probable.

 
10

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Summary of Significant Accounting Policies, continued
 
Some of the Company’s videogames provide limited online features at no additional cost to the consumer. Generally, the Company considers such features to be incidental to the overall product offering and an inconsequential deliverable. Accordingly, the Company recognizes revenue related to videogames containing these limited online features upon the transfer of title and risk of loss to the customer.  In instances where online features or additional functionality are considered a substantive deliverable in addition to the videogame, the Company takes this into account when applying its revenue recognition policy.  This evaluation is performed for each videogame together with any online transactions, such as electronic downloads or videogame add-ons when it is released.  When the Company determines that a videogame contains online functionality that constitutes a more-than-inconsequential separate service deliverable in addition to the videogame, principally because of its importance to game play, the Company considers that its performance obligations for this game extend beyond the delivery of the game. Fair value does not exist for the online functionality, as the Company does not separately charge for this component of the videogame. As a result, the Company recognizes all of the revenue from the sale of the game upon the delivery of the remaining online functionality.  In addition, the Company defers the costs of sales for this game and recognizes the costs upon delivery of the remaining online functionality.
 
With respect to online transactions, such as electronic downloads of games or add-ons that do not include a more-than-inconsequential separate service deliverable, revenue is recognized when the fee is paid by the online customer to purchase online content and the Company is notified by the online retailer that the product has been downloaded. In addition, persuasive evidence of an arrangement must exist, collection of the related receivable must be probable and the fee must be fixed and determinable.
 
Third-party licensees in Europe distribute Gamecock’s videogames under license agreements with Gamecock. The licensees paid certain minimum, non-refundable, guaranteed royalties when entering into the licensing agreements. Upon receipt of the advances, the Company defers their recognition and recognizes the revenues in subsequent periods as these advances are earned by the Company. As the licensees pay additional royalties above and beyond those initially advanced, the Company recognizes these additional royalties as revenues when earned.
 
With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of a master copy. Per copy royalties on sales that exceed the guarantee are recognized as earned.  In addition, persuasive evidence of an arrangement must exist, collection of the related receivable must be probable, and the fee must be fixed and determinable. 
 
Consideration Given to Customers and Received from Vendors
 
The Company offers sales incentives and other consideration to its customers.  Sales incentives and other consideration that are considered adjustments of the selling price of the Company’s games, such as rebates and product placement fees, are reflected as reductions to revenue.  Sales incentives and other consideration that represent costs incurred by the Company for assets or services received, such as the appearance of games in a customer’s national circular ad, are reflected as sales and marketing expenses.
 
Cost of Goods Sold
 
Cost of goods sold includes: manufacturing costs, royalties, and amortization of intellectual property licenses.
 
Stock-Based Compensation
 
The Company estimates the fair value of share-based payment awards on the measurement date using the Black-Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations.
 
Stock-based compensation expense recognized in the consolidated statements of operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. Stock compensation guidance requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 
11

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Summary of Significant Accounting Policies, continued
 
The Company estimates the value of employee stock options on the date of grant using the Black-Scholes option pricing model. The Company’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to; the expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.
 
The Company accounts for equity instruments issued to non-employees based on the estimated fair value of the equity instrument that is recorded on the earlier of the performance commitment date or the date the services required are completed.  Until shares under the award are fully vested, the Company marks-to-market the fair value of the options at the end of each accounting period.
 
Fair Value Measurements
 
Effective July 1, 2009, the Company adopted the provisions of the fair value measurement accounting and disclosure guidance related to non-financial assets and liabilities recognized or disclosed at fair value on a nonrecurring basis. This standard establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements, and clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The provisions also establish a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The guidance requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:
 
 
·
Level 1: Quoted market prices in active markets for identical assets or liabilities.
 
 
·
Level 2: Quoted prices in active markets for similar assets and liabilities, quoted prices for identically similar assets or liabilities in markets that are not active and models for which all significant inputs are observable either directly or indirectly.
 
 
·
Level 3: Unobservable inputs reflecting the reporting entity’s own assumptions or external inputs for inactive markets.
 
The determination of where assets and liabilities fall within this hierarchy is based upon the lowest level of input that is significant to the fair value measurement. While the Company has previously invested in certain assets that would be classified as “level 1,” as of September, 2009, the Company does not hold any “level 1” cash equivalents that are measured at fair value on a recurring basis, nor does the Company have any assets or liabilities that are based on “level 2” or “level 3” inputs.
 
Comprehensive Income (Loss)

For the three months ended September 30, 2009 and 2008, the Company's comprehensive income (loss) was as follows:

   
Three months ended
   
September 30,
2009
   
September 30,
2008
 
Net income (loss)
 
$
686,981
   
$
(1,551,754
Other comprehensive income (loss)
               
Change in foreign currency translation adjustment
   
82,500
     
(95,363
Comprehensive income (loss)
 
$
769,481
   
$
(1,647,117
 
 
12

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Summary of Significant Accounting Policies, continued
 
Earnings (Loss) Per Common Share
 
Basic earnings (loss) per share is computed by dividing net income (loss) attributable to common shareholders by the weighted average number of common shares outstanding for all periods.  Diluted earnings per share is computed by dividing net income (loss) attributable to common shareholders by the weighted average number of shares outstanding, increased by common stock equivalents.  Common stock equivalents represent incremental shares issuable upon exercise of outstanding options and warrants, the conversion of preferred stock and the vesting of restricted stock. However, potential common shares are not included in the denominator of the diluted earnings (loss) per share calculation when inclusion of such shares would be anti-dilutive, such as in a period in which a net loss is recorded.  Potentially dilutive securities including outstanding options, warrants, restricted stock, and the conversion of preferred stock amounted to 17,648,624 for the three months ended September 30, 2008.
 
Reclassifications
 
Certain prior period amounts have been reclassified to conform to current year presentations. The reclassifications did not impact previously reported total assets, liabilities, shareholders’ equity or net loss.
 
Recent Accounting Pronouncements
 
The Financial Accounting Standards Board (“FASB”) has codified a single source of U.S. GAAP, the “Accounting Standards Codification.” Unless needed to clarify a point to readers, the Company will refrain from citing specific section references when discussing application of accounting principles or addressing new or pending accounting rule changes.
 
During September 2009, the Emerging Issues Task Force (“EITF”) issued EITF 08-1, “Revenue Arrangements with Multiple Deliverables” and EITF 09-3, “Applicability of Statement of Position 97-2 to Certain Arrangements that include Software Elements.”  EITF 08-1 modifies the requirements for determining whether deliverables meet the separate unit of accounting criteria and requires allocation of arrangement consideration based on relative selling price.  EITF 09-3 provides more guidance on whether transactions should be accounted for under SOP 97-2, “Software Revenue Recognition.” The Company must adopt EITF 08-1 and EITF 09-3 at the same time, no later than in the first fiscal year beginning after June 15, 2010, but earlier adoption is permitted.  Companies may adopt prospectively or retrospectively.  The Company is currently evaluating the impact that the adoption of EITF 08-1 and EITF 09-3 will have on the Company’s consolidated financial position and results of operations.
 
2. Gamecock Acquisition
 
On October 10, 2008, the Company acquired Gamecock pursuant to a definitive purchase agreement (the “Gamecock Agreement”) with Vid Agon, LLC (the “Seller”) and Vid Sub, LLC (the “Member”). The Member is a wholly-owned subsidiary of the Seller and Gamecock is a wholly-owned subsidiary of the Member.  Pursuant to the terms of the Gamecock Agreement, the Company acquired all of the outstanding membership interests of the Member in exchange for aggregate consideration of 7% of the future revenues from sales of certain Gamecock games, net of certain distribution fees and advances, and a warrant to purchase 700,000 shares of the Company’s common stock.
 
The amount of the contingent purchase price payment obligations (the “Gamecock Earn-Out”) will be added to the purchase price (i.e., goodwill) when the contingency is resolved.
 
The purchase price of Gamecock consists of the following items:
 
Fair value of 700,000 warrants to purchase common stock with an exercise price of $1.50 per share based on the closing date of the transaction, October 10, 2008
 
$
1,033,164
 
Transaction costs
   
750,000
 
Total initial purchase consideration
 
$
1,783,164
 
 
 
13

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
2. Gamecock Acquisition, continued
 
The fair value of the stock warrants was determined using the Black-Scholes option pricing model and the following assumptions: (a) the fair value of the Company’s common stock of $2.35 per share, which is the closing price as of October 10, 2008, (b) volatility of 57.68%, (c) a risk free interest rate of 2.77%, (d) an expected term, also the contractual term, of 5.0 years, and (e) an expected dividend yield of 0.0%.
 
The allocation of the purchase price below was based upon a valuation and the Company’s estimates and assumptions are subject to change. The primary areas of those purchase price allocations that are not finalized relate to certain intangible assets and residual goodwill. Any material adjustments to this purchase price allocation in future periods will be disclosed.
 
The valuation of acquired assets and liabilities performed in part by an unrelated third-party valuation firm is as follows:
 
Working capital, excluding inventories
 
$
827,287
 
Inventories
 
156,745
 
Other current assets
 
36,369
 
Property and equipment
 
209,441
 

 
Estimated useful
life
     
Intangible assets:
       
     Royalty agreements (Advances on royalties)
1 – 2 years
 
3,424,000
 
     Game sequel titles
5 – 12 years
 
1,142,000
 
     Non-compete agreements
Less than 1 year
 
200,000
 
     Distribution agreements
3 years
 
40,000
 
     Goodwill
Indefinite
   
6,539,700
 
Liabilities
     
(10,792,378
     Total initial purchase consideration
   
$
1,783,164
 
 
The following table presents the gross and net balances, and accumulated amortization of the components of the Company’s purchased amortizable intangible assets included in the acquisition as of September 30, 2009:
 
         
Accumulated
       
   
Gross
   
Amortization
   
Net
 
                   
Royalty agreements (Advances on royalties)
 
$
3,424,000
   
$
2,626,352
   
$
797,648
 
Intangible assets, net
                       
Game sequel titles
 
$
1,142,000
   
$
1,142,000
   
$
-
 
Non-compete agreements
   
200,000
     
200,000
     
-
 
Distribution agreements
   
40,000
     
12,975
     
27,025
 
                         
Total intangible assets, net
 
$
1,382,000
   
$
1,354,975
   
$
27,025
 
 
Intangible assets and goodwill are expected to be tax deductible.  During the year ended June 30, 2009, the Company incurred an impairment charge of $1,142,000 related to write-off of acquired game sequel titles due to the underperformance of the acquired titles.

 
14

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
2. Gamecock Acquisition, continued
 
The estimated future decreases (increases) to net income (loss) from the amortization of the finite-lived intangible assets are the following amounts:
 
Year ending June 30,
     
 
2010 (nine months ended June 30, 2010)
  $ 10,000  
2011
  $ 13,333  
2012
  $ 3,692  
 
The weighted average estimated amortization period as of September 30, 2009 is 24 months.
 
As of September 30, 2009, a total of $1,472,687, which may be netted contractually against adjustments for excess payables, as defined pursuant to the Gamecock Agreement, of the Gamecock Earn-Out has been achieved and was included to goodwill in the consolidated balance sheets.

The following table summarizes the unaudited pro forma information assuming the business combination had occurred at the beginning of the periods presented.  This pro forma financial information is for informational purposes only and does not reflect any operating efficiencies or inefficiencies which may result from the business combination and therefore is not necessarily indicative of results that would have been achieved had the businesses been combined during the periods presented.
 
 
For the three months ended
September 30,
 
 
2008
 
Pro forma net revenues
 
$
9,033,730
 
Pro forma net loss
   
(36,805,975
)
Pro forma net loss per share—basic
 
 $
(1.02
)
Pro forma net loss per share—diluted
 
 $
(1.02
)
 
On December 4, 2008, the Company acquired the remaining 4% minority interest in Gamecock in exchange for aggregate consideration of 50,000 warrants to purchase shares of the Company’s common stock, with an exercise price of $1.50 per share, exercisable subject to the achievement of certain revenue targets. The transaction has been accounted for as a purchase and resulted in an increase to goodwill of $18,889.  The fair value of the stock warrants was determined using the Black-Scholes option pricing model and the following assumptions: (a) the fair value of the Company’s common stock of $1.10 per share, which is the closing price as of December 4, 2008, (b) volatility of 63.76%, (c) a risk free interest rate of 1.51%, (d) an expected term, also the contractual term, of 3.0 years, and (e) an expected dividend yield of 0.0%.

3. Inventories
 
At September 30, 2009 and June 30, 2009, inventories consist of the following:
 
   
September 30,
2009
   
June 30,
2009
 
Finished goods
 
$
4,710,305
   
$
3,858,518
 
Purchased parts and components
   
3,286,346
     
601,319
 
Total
 
$
7,996,651
   
$
4,459,837
 
 
 
15

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
4. Property and Equipment, net
 
At September 30, 2009 and June 30, 2009, property and equipment, net was comprised of the following:
 
   
September 30,
2009
   
June 30,
2009
 
Land
 
$
544,044
   
$
544,044
 
Building and leasehold improvements
   
1,496,098
     
1,496,147
 
Computer equipment and software
   
736,774
     
719,621
 
Office furniture and other equipment    
   
357,739
     
353,406
 
     
3,134,655
     
3,113,218
 
                 
Less: accumulated depreciation and amortization
   
406,525
     
359,079
 
                 
Property and equipment, net
 
$
2,728,130
   
$
2,754,139
 
 
Depreciation and amortization expense for the three months ended September 30, 2009 and 2008 was $47,982 and $36,209, respectively.
 
5. Line of Credit
 
The Company has a $7.5 million revolving line of credit facility with a financial institution that expires on November 30, 2009. From time to time the financial institution in its sole and absolute discretion may increase the Company’s line of credit in the form of an overadvance agreement. As of September 30, 2009 and June 30, 2009, the Company’s borrowing base may not exceed 65% of eligible accounts receivable plus $500,000. The line of credit bears interest at prime plus ½%, which was 3.75% at September 30, 2009 and June 30, 2009. The financial institution processes payments received on such accounts receivable as payments on the revolving line of credit. The line is collateralized by gross accounts receivable of approximately $13,103,000 and $8,673,000 at September 30, 2009 and June 30, 2009, respectively. The line of credit is further collateralized by personal guarantees, and pledge of personal securities and assets by two Company shareholders, one of whom is the Company’s chairman, and certain other affiliates. The agreement contains certain financial and non-financial covenants. At September 30, 2009, the Company was in compliance with these covenants.
 
At September 30, 2009 and June 30, 2009, the outstanding line of credit balance was $7,123,865 and $5,349,953, respectively. At September 30, 2009 and June 30, 2009, the Company had $876,135 and $-0-, respectively, available under its credit facility. For the three months ended September 30, 2009 and 2008, interest expense relating to the line of credit was $51,759 and $31,132, respectively.
 
6. Long-term Debt
 
At September 30, 2009 and June 30, 2009, long-term debt was comprised of the following:
 
   
September 30,
2009
   
June 30,
2009
 
Mortgages payable
           
    First National Bank
 
$
1,033,150
   
$
1,039,078
 
    Southwest Securities, FSB
   
489,955
     
493,437
 
Vehicle note payable
   
54,853
     
57,296
 
                 
Total debt
   
1,577,958
     
1,589,811
 
Less current portion
   
51,697
     
50,855
 
Total long-term debt
 
$
1,526,261
   
$
1,538,956
 
 
 
16

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
6. Long-term Debt, continued
 
In connection with the purchase of an office building in Grapevine, Texas, the Company entered into a five year mortgage with a financial institution in the amount of $500,000.  The interest rate on the mortgage adjusts daily to prime plus 1.0% (5.5% at September 30, 2009).  Principal and interest are payable in monthly installments of $3,439 continuing until January 28, 2014 when the entire balance of principal and accrued interest is due and payable.  The mortgage is secured by the land and building. The Company’s chairman has personally guaranteed the mortgage note.
 
 
In connection with the purchase of an office building and land in Grapevine, Texas, the Company entered into a 20 year mortgage with a financial institution in the amount of $1,068,450. The interest rate on the mortgage adjusts every five years to prime minus ¼% (7.5% at September 30, 2009). The monthly principal and interest payment is $8,611 with interest only payments for the first six months. The mortgage is secured by the purchased land and building. Two shareholders of the Company, one of whom is the Company’s chairman, have personally guaranteed the mortgage note.
 
 
The scheduled maturities of the long-term debt are as follows:
 
Year ending June 30,
     
2010 (nine months ended June 30, 2010)
 
$
39,002
 
2011
   
54,478
 
2012
   
58,363
 
2013
   
62,530
 
2014
   
478,008
 
Thereafter
   
885,577
 
         
Total
   
1,577,958
 
         
Less: current maturities
   
51,697
 
         
Long-term debt, net of current portion
 
$
1,526,261
 

7. Related Party Transactions
 
Related Party Receivables
 
Related party receivables consist of short-term advances to employees and an overpayment of amounts owed to an affiliate of two shareholders of the Company, one of whom is the Company’s chairman. No allowance has been provided due to the short-term nature and recoverability of such advances.
 
Due to Shareholders
 
During the year ended June 30 2009, the Company’s chairman advanced the Company $307,440. The advance was unsecured, payable on demand and non-interest bearing.  Subsequent to June 30, 2009, the amount was repaid.  At September 30, 2009 and June 30, 2009, the amount due was $0 and $232,440, respectively.
 
Due to Related Parties
 
During the year ended June 30, 2009, the Company collected sales commissions totaling $226,216 on behalf of an affiliate of two shareholders of the Company, one of whom is the Company’s chairman.  At June 30, 2009,  $113,499 was payable to the affiliate and is included in due to related parties in the accompanying consolidated balance sheets.  At September 30, 2009, the Company was owed $38,390 from this affiliate, resulting from an overpayment of amounts owed.  This amount is classified as related party receivables at September 30, 2009 in the accompanying consolidated balance sheets.

 
17

 
SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
7. Related Party Transactions, continued
 
During the three months ended September 30, 2009 and 2008, the Company expensed $6,600 and $20,850, respectively, related to broadband usage from an internet service provider partially owned by two shareholders of the Company, one of whom is the Company’s chairman, of which $2,200 and $11,546 remained as a payable to the affiliate and is included in due to related parties in the accompanying consolidated balance sheets at September 30, 2009 and June 30, 2009, respectively.  These amounts are included in general and administrative expenses in the accompanying consolidated statements of operations.
 
Accrued Expenses - Related Parties
 
Accrued expenses - related parties as of and for the three months ended September 30, 2009 and the year ended June 30, 2009 are as follows:
 
   
Three months ended
September 30,
2009
   
Year ended
June 30,
2009
 
Balance at beginning of period
 
$
184,766
   
$
5,770
 
Expenses incurred:
               
Rent
   
27,500
     
100,250
 
Commissions
   
93,066
     
705,032
 
Less: amounts paid
   
(225,841
)
   
(626,286
)
Balance at end of period
 
$
79,491
   
$
184,766
 
 
The Company incurred sales commissions for the marketing and sale of videogames with two affiliates of the Company’s chairman.  Sales commissions for the three months ended September 30, 2009 and 2008 were $93,066 and $147,599, respectively.  These amounts are included in sales and marketing in the accompanying consolidated statements of operations.
 
Lease - Related Parties
 
The Company leases certain office space from a company whose shareholders are also shareholders of the Company, one of whom is the Company’s chairman.  Related party lease expense was $27,500 and $22,625 for the three months ended September 30, 2009 and  2008, respectively.  These amounts are included in the general and administrative expense in the accompanying consolidated statements of operations. The lease expires on December 31, 2010.
 
The Company leases certain office space to a company whose shareholders are also shareholders of the Company, one of whom is the Company’s chairman.  Related lease income was $-0- and $3,907 for the three months ended September 30, 2009 and 2008, respectively.  These amounts are included in general and administrative expense in the accompanying consolidated statements of operations.  The lease expires on December 31, 2010.
 
8. Commitments
 
Total future minimum commitments are as follows:
 
   
Software
   
Office
       
   
Developers
   
Lease
   
Total
 
For the year ending June 30,
                 
                   
2010 (nine months ended June 30, 2010)
  $ 8,928,364     $ 119,544     $ 9,047,908  
2011
    788,000       88,999       876,999  
2012
    -       33,999       33,999  
2013
    -       31,166       31,166  
Total
  $ 9,716,364     $ 273,708     $ 9,990,072  

 
18

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
8. Commitments, continued
 
Developer of Intellectual Property Contracts
 
The Company regularly enters into contractual arrangements with third parties for the development of games as well as the rights to license intellectual property. Under these agreements, the Company commits to provide specified payments to a developer or intellectual property holders, based upon contractual arrangements, and conditioned upon the achievement of specified development milestones. These payments to third-party developers and intellectual property holders typically are deemed to be advances and are recouped against future royalties earned by the developers based on the sale of the related game. On October 26, 2007, the Company executed an agreement with a third party game developer in connection with certain development agreements. Pursuant to the agreement, the Company has committed to spend specified amounts for marketing support of the related game which is to be developed. “Cost of goods sold - royalties” related to this development agreement amounted to $5,000,671 and $808,921 for the three months ended September 30, 2009 and 2008, respectively.
 
Lease Commitments
 
In January 2008, the Company entered into a new four year lease for its United Kingdom office, with a yearly rent of approximately $30,000 plus value added tax (VAT).  Prior to this lease, the United Kingdom office had a one year lease for office space beginning in December 2007, with a monthly rent of approximately $5,200.  Office rent expense for the three months ended September 30, 2009 and 2008 was $5,862 and $17,099, respectively.
 
The Company entered into a non-cancelable operating lease with an affiliate, on January 1, 2008, for offices located in Midlothian, Virginia. The lease provided for monthly payments of $7,542 for the first 12 months and increased to $9,167 in January 2009 for the remaining 24 months. Office rent expense for the three months ended September 30, 2009 and 2008 was $27,500 and $22,625, respectively.
 
Employment Agreements
 
The Company has employment agreements with several members of senior management. The agreements, with terms ranging from approximately two to three years, provide for minimum salary levels, performance bonuses, and severance payments.
 
9. Stock-based Compensation
 
In May 2008, the Company’s board of directors and its shareholders approved the 2008 Equity Incentive Compensation Plan (the “2008 Plan”) for the grant of stock awards, including restricted stock and stock options, to officers, directors, employees and consultants.  The 2008 Plan expires in May 2018. Shares available for future grant as of September 30, 2009 and June 30, 2009 were 2,610,867 and 2,924,200, respectively, under the 2008 Plan.
 
Stock awards and shares are generally granted at prices which the Company’s board of directors believes approximate the fair market value of the awards or shares at the date of grant. Individual grants generally become exercisable ratably over a period of three years from the date of grant. The contractual terms of the options range from three to ten years from the date of grant.
 
The Company uses the Black-Scholes option pricing model to determine the fair value of stock-based compensation to employees and non-employees. The determination of fair value is affected by the Company’s stock price and volatility, employee exercise behavior, and the time for the shares to vest.

 
19

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
9. Stock-based Compensation, continued
 
The assumptions used in the Black-Scholes option pricing model to value the Company’s option grants  to employees and non-employees were as follow:
 
   
For the three
months ended
September 30, 2009
   
For the three
months ended
September 30, 2008
 
Risk-free interest rate
    2.5 – 3.5 %     4.01
Weighted-average volatility
    161 – 165 %     57.56 %
Expected term
 
5.5 – 9.7 years
   
6 years
 
Expected dividends
    0.0 %     0.0 %
 
The following table summarizes the stock-based compensation expense resulting from stock options and restricted stock in the Company’s consolidated statements of operations:
 
   
For the three
months ended
September 30, 2009
   
For the three
months ended
September 30, 2008
 
Sales and marketing
  $ 27,622     $ 37,734  
General and administrative
    128,574       126,628  
Total stock-based compensation expense
  $ 156,196     $ 164,362  
 
As of September 30, 2009, the Company’s unrecognized stock-based compensation for stock options issued to employees and non-employee directors was approximately $794,000 and will be recognized over a weighted average of 1.8 years.  The Company estimated a 5% forfeiture rate related to the stock-based compensation expense calculated for employees and non-employee directors.
 
The following table summarizes the Company’s stock option activity for employees, non-employee directors, and non-employees for the three months ended September 30, 2009:
 
   
Options
   
Weighted-
Average
Exercise
Price
   
Weighted-
Average
Remaining
Contractual
Term
(in years)
   
Aggregate
Intrinsic
Value
 
Outstanding as of June 30, 2009
   
1,960,300
   
$
1.69
     
-
   
$
-
 
Activity for the three months ended September 30, 2009
                               
Granted
   
328,000
     
0.74
     
     
-
 
Exercised
   
-
     
-
     
     
-
 
Forfeited, cancelled or expired
   
79,667
     
1.83
     
     
-
 
Outstanding as of September 30, 2009
   
2,208,633
   
$
1.54
     
8.31
   
$
-
 
Exercisable as of September 30, 2009
   
328,333
   
$
2.30
     
8.75
   
$
-
 
Exercisable and expected to be exercisable
   
2,032,773
   
$
1.56
     
8.27
   
$
-
 
 
The aggregate intrinsic value represents the total pre-tax intrinsic value based on the Company’s closing stock price ($0.51 per share) as of September 30, 2009, which would have been received by the option holders had all option holders exercised their options as of that date.
 
The weighted average fair value of stock options granted to employees and non-employee directors during the three months ended September 30, 2009 was $0.70 per share.

 
20

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
9. Stock-based Compensation, continued
 
The following table summarizes the Company’s restricted stock activity for the three months ended September 30, 2009:
 
   
Shares
   
Weighted-
Average
Grant Date
Fair Value
 
Outstanding as of June 30, 2009
   
115,500
   
$
2.14
 
Activity for the three months ended September 30, 2009
               
Granted
   
65,000
     
0.75
 
Vested
   
91,500
     
2.30
 
Forfeited, cancelled or expired
   
-
     
-
 
Outstanding as of September 30, 2009
   
89,000
   
$
0.96
 
Vested as of September 30, 2009
   
91,500
   
$
2.30
 
 
10. Contingencies
 
The Company was obligated to file a registration statement with the SEC covering the resale of the shares of its common stock issued upon conversion of the Series A convertible preferred stock and the exercise of Class Y warrants within 30 days following the Company’s filing of its Form 10-K for the fiscal year in 2008 but no later than January 15, 2009. The Company filed a registration statement on Form S-1 with the SEC, however, the registration statement was not declared effective by the SEC within the prescribed time period.
 
Since the registration statement was not declared effective by the SEC within the prescribed time period, the Company is obligated to make pro rata payments to each holder of Series A convertible preferred stock in an amount equal to .5% of the aggregate amount invested by such holder of Series A convertible preferred stock for each 30 day period (or portion thereof) for which no registration statement is effective. Accordingly, the Company has recognized a liability for liquidating damages and interest totaling $196,511 for the year ended June 30, 2009.  The amount of the liability at September 30, 2009 and June 30, 2009 was $196,511.
 
The Company is engaged in ordinary routine litigation incidental to the Company’s business to which the Company is a party. While the Company cannot predict the ultimate outcome of these various legal proceedings, it is management’s opinion that the resolution of these matters should not have a material effect on the consolidated financial position or results of operations of the Company.
 
On March 12, 2009, the Company, Gamecock, SouthPeak Interactive, Ltd. and Gamecock Media Europe, Ltd. were served with a complaint by a videogame distributor alleging a breach of contract and other claims related to a publishing and distribution agreement, or the Distribution Agreement, entered into between Gamecock Media Europe, Ltd. and the videogame distributor in January 2008. The videogame distributor is seeking the return of $4,590,000 in advances, an injunction against the Company and its subsidiaries, approximately $650,000 in specified damages, further damages to be assessed, and discretionary interest and costs.  Gamecock Media Europe, Ltd. has filed a counterclaim against the videogame distributor for $950,000 and discretionary interest and costs, resulting from videogame sales and the achievement of a milestone under the Distribution Agreement.  The case was heard in the United Kingdom in July 2009 and closing submissions were made to the court on or about July 22, 2009.  The court has reserved judgment and the Company expects a decision in the near future.  As part of the court proceedings between the Company and the videogame distributor, the Company agreed (to avoid further costly hearings) to pay 35% of certain European sales into an escrow account pending the final resolution of the case.  As of September 30, 2009, the amount held in escrow was approximately $827,665 and is included in restricted cash.  Legal expenses associated with this complaint have been expensed as incurred.  The Company’s management currently believes that resolution of this matter will not have a material adverse effect on the Company’s consolidated financial position or results of operations. However, legal issues are subject to inherent uncertainties and there exists the possibility that the ultimate resolution of this matter could have a material adverse effect on the Company’s consolidated financial position and the results of operations in the period in which any such effect is recorded.

 
21

 

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
10. Contingencies, continued
 
On October 27, 2008, Gamecock was served with a demand for arbitration by a developer alleging various breaches of contract related to a publishing agreement entered into between Gamecock and the developer on December 12, 2007. The developer is seeking an award of $4,910,000, termination of the agreement, exclusive control of the subject videogame, and discretionary interest and costs. Gamecock has responded stating that the developer’s attempts to terminate the publishing agreement constitute wrongful termination of the agreement and breach of the agreement. Gamecock has also filed a counterclaim against the developer seeking the return of approximately $5.9 million in advances on royalties in the event the publishing agreement is terminated.  The developer has filed a supplemental demand for arbitration concerning royalty payments due under a separate publishing agreement and is seeking an award of $41,084.  The arbitration hearing has been scheduled for January 2010.  As of September 30, 2009, no amounts have been accrued related to this matter.  The Company’s management currently believes that resolution of this matter will not have a material adverse effect on the Company’s consolidated financial position or results of operations. However, legal issues are subject to inherent uncertainties and there exists the possibility that the ultimate resolution of this matter could have a material adverse effect on the Company’s consolidated financial position and the results of operations in the period in which any such effect is recorded.
 
On August 26, 2009, the Company was notified that the SEC was conducting a non-public, fact-finding investigation regarding certain matters underlying the amendment of its Form 10-Q, and the restatement of its financial statements, for the period ended March 31, 2009, and the termination of its former chief financial officer.  The Company has provided the SEC with the documents requested and intends to cooperate in all respects with the SEC’s investigation.
 
11. Production Advance Payable
 
On August 13, 2009, the Company entered into a unit production financing agreement with a producer relating to the production of certain games, of which the balance under this agreement was $3,755,104 at September 30, 2009.  Production fees relating to this production advance for the three months ended September 30, 2009 totaled $199,946 and are included in interest expense. As of September 30, 2009, accrued and unpaid production fees totaled approximately $200,000 and are included in accrued expenses and other current liabilities. The Company is obligated to pay approximately $103,000 of production fees for every month the full production advance is outstanding past its due date of November 14, 2009.  Pursuant to the agreement, the Company has assigned to the producer a portion of the net revenues related to the sale of certain games in Europe.
 
 
22

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this report and in our annual report on Form 10-K for the year ended June 30, 2009.

This report includes forward-looking statements that are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified by the use of words such as “anticipate,” “believe,” “estimate,” “may,” “intend,” “expect,” “will,” “should,” “seeks” or other similar expressions. Forward-looking statements reflect our plans, expectations and beliefs, and involve inherent risks and uncertainties, many of which are beyond our control. You should not place undue reliance on any forward-looking statement, which speaks only as of the date made. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in “Risk Factors” in Item 1A of Part II.

Overview
 
We are an independent developer and publisher of interactive entertainment software. We utilize our network of independent studios and developers to create videogames for all popular videogame systems, including:
 
 
·
home videogame consoles such as Microsoft Xbox 360, Nintendo Wii, Sony PlayStation 3 and Sony PlayStation 2;
 
 
·
handheld platforms such as Nintendo DS, Nintendo DSi, Sony PSP, Sony PSPgo, and Apple iPhone; and
 
 
·
personal computers.
 
Our portfolio of games extends across a variety of consumer demographics, ranging from adults to children and hard-core game enthusiasts to casual gamers.
 
We are an “indie” videogame developer and publisher working with independent software developers and videogame studios to create our videogames. We have cultivated relationships globally with independent developers and studios that provide us with innovative and compelling videogame concepts.
 
Our strategy is to establish a portfolio of successful proprietary content for the major videogame systems, and to capitalize on the growth of the interactive entertainment market. We currently work exclusively with independent software developers and videogame studios to develop our videogames. This strategy enables us to source and create highly innovative videogames while avoiding the high fixed costs and risk of having a large internal development studio. Through outsourcing, we are also able to access videogame concepts and content from emerging studios globally, providing us with significant new product opportunities with limited initial financial outlay.
 
Sources of Revenue
 
Revenue is primarily derived from the sale of software titles developed on our behalf by independent software developers and videogame studios.  Our unique business model of globally sourcing and developing creative product allows us to better manage our fixed costs relative to our competition.  In North America, we sell our videogames both to retailers and distributors, and in Europe, Australia and Asia, we primarily sell our videogames to distributors.
 
Our operating margins are dependent in part upon our ability to continually release new products that perform according to our budgets and forecasts, and manage our product development costs. Our product development costs include license acquisition, videogame development, and third-party royalties. Agreements with third-party developers generally give us exclusive publishing and marketing rights and require us to make advance royalty payments, pay royalties based on product sales, and satisfy other conditions.

 
23

 

First Quarter 2010 Releases
 
We released the following videogames in the three months ended September 30, 2009:
 
Title
 
Platform
 
Date Released
EU Rome Gold
 
PC
 
7/7/2009
East India Company
 
PC
 
7/9/2009
Brave: A Warrior’s Tale
 
X360, Wii
 
8/1/2009
Hearts of Iron 3
 
PC
 
8/3/2009
Raven Squad: Hidden Dagger
 
X360, PC
 
8/21/2009
Section 8
 
X360, PC
 
8/26/2009
Trine
 
PC
 
9/4/2009
Majesty 2: The Fantasy Kingdom
 
PC
 
9/16/2009
Supreme Ruler 2020
 
PC
 
9/17/2009
Fallen Earth
 
PC
 
9/28/2009
 
Cost of Goods Sold and Operating Expenses
 
Cost of Goods Sold. Cost of goods sold consists of royalty payments to third-party developers, license fees to videogame manufacturers, intellectual property costs for items such as trademarked characters and game engines, and manufacturing costs of videogame discs, cartridges or similar media. Videogame system manufacturers approve and manufacture each videogame for their videogame system.  The videogame system manufacturers charge us a license fee for each videogame based on the number of videogames manufactured.  Should some of the videogames ultimately not be sold, or the sales price to the retailer be reduced by us through price protection, no adjustment is made by the videogame system manufacturer to the license fee originally charged.  Because of the terms of these license fees, we may have an increase in the cost of goods sold as a percent of net revenue should we fail to sell a number of copies of a videogame for which a license has been paid, or if the price to the retailer is reduced.
 
We utilize third-parties to develop our videogames on a royalty payment basis. We enter into contracts with independent software developers and videogame studios once the videogame design has been approved by the videogame system manufacturer and is technologically feasible.  Payments to independent software developers and videogame studios are made when certain contract milestones are reached, and these payments are capitalized. These payments are considered non-refundable royalty advances and are applied against the royalty obligations owing to the independent software developer or videogame studio from the sales of the videogame. To the extent these prepaid royalties are sales performance related, the royalties are expensed against projected sales revenue at the time a videogame is released and charged to costs of goods sold. Any pre-release milestone payments that are not prepayments against future royalties are expensed when a videogame is released and then charged to costs of goods sold. Capitalized costs for videogames that are cancelled or abandoned prior to product release are charged to “cost of goods sold - royalties” in the period of cancellation.
 
Warehousing and Distribution Expenses. Our warehousing and distribution expenses primarily consist of costs associated with warehousing, order fulfillment, and shipping. Because we use third-party warehousing and order fulfillment companies in North America and in Europe, the expansion of our product offerings and escalating sales will increase our expenditures for warehousing and distribution in proportion to our increased sales.
 
Sales and Marketing Expenses. Sales and marketing expenses consist of salaries and related costs, advertising, marketing and promotion expenses, and commissions to external sales representatives. As we release more newly published videogames, advertising, marketing and promotion expenses are expected to rise accordingly. We recognize advertising, marketing and promotion expenses as incurred, except for production costs associated with media advertising, which are deferred and charged to expense when the related ad is run for the first time. We also engage in cooperative marketing with some of our retail channel partners. We accrue marketing and sales incentive costs when revenue is recognized and such amounts are included in sales and marketing expense when an identifiable benefit to us can be reasonably estimated; otherwise, the incentives are recognized as a reduction to net revenues. Such marketing is offered to our retail channel partners based on a single sales transaction, as a credit on their accounts receivable balance, and would include items such as contributing to newspaper circular ads and in-store banners and displays.
 
General and Administrative Expenses. General and administrative expenses primarily represent personnel-related costs, including corporate executive and support staff, general office expenses, consulting and professional fees, and various other expenses. Personnel-related costs represent the largest component of general and administrative expenses. We expect that our personnel costs will increase as the business continues to grow.  Depreciation expense also is included in general and administrative expenses.

 
24

 

Interest and Financing Costs. Interest and financing costs are attributable to our line of credit and financing arrangements that are used to fund development of videogames with independent software developers and videogame studios. Additionally, such costs are used to finance accounts receivables prior to payment by customers.
 
Critical Accounting Policies and Estimates
 
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Estimates were based on historical experience and on various other assumptions that we believe 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 could differ materially from these estimates under different assumptions or conditions.
 
Our significant accounting policies are described in Note 1 to the accompanying consolidated financial statements and in our annual report on Form 10-K for the year ended June 30, 2009. The following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.
 
Allowances for Returns, Price Protection and Other Allowances. We accept returns from, and grant price concessions to, our customers under certain conditions. Following reductions in the price of our videogames, we grant price concessions to permit customers to take credits against amounts they owe us with respect to videogames unsold by them. Our customers must satisfy certain conditions to entitle them to return videogames or receive price concessions, including compliance with applicable payment terms and confirmation of field inventory levels and sell-through rates.
 
We make estimates of future videogame returns and price concessions related to current period revenue. We estimate the amount of future returns and price concessions for published titles based upon, among other factors, historical experience and performance of the titles in similar genres, historical performance of the videogame system, customer inventory levels, analysis of sell-through rates, sales force and retail customer feedback, industry pricing, market conditions and changes in demand and acceptance of our videogame by consumers.
 
Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price concessions in any accounting period. We believe we can make reliable estimates of returns and price concessions. However, actual results may differ from initial estimates as a result of changes in circumstances, market conditions and assumptions. Adjustments to estimates are recorded in the period in which they become known.
 
Inventories. Inventories are stated at the lower of average cost or market. Management regularly reviews inventory quantities on hand and in the retail channel and records a provision for excess or obsolete inventory based on the future expected demand for our games. Significant changes in demand for our games would impact management’s estimates in establishing the inventory provision.
 
Advances on Royalties. We utilize independent software developers to develop our videogames and make payments to the developers based upon certain contract milestones. We enter into contracts with the developers once the videogame design has been approved by the videogame system manufacturers and is technologically feasible. Accordingly, we capitalize such payments to the developers during development of the videogames. These payments are considered non-refundable royalty advances and are applied against the royalty obligations owed to the developer from future sales of the videogame. Any pre-release milestone payments that are not prepayments against future royalties are expensed to “cost of goods sold - royalties” in the period when the game is released. Capitalized royalty costs for those videogames that are cancelled or abandoned are charged to “cost of goods sold - royalties” in the period of cancellation.
 
Beginning upon the related videogame’s release, capitalized royalty costs are amortized to “cost of goods sold – royalties,” based on the ratio of current revenues to total projected revenues for the specific videogame, generally resulting in an amortization period of twelve months or less.
 
We evaluate the future recoverability of capitalized royalty costs on a quarterly basis. For videogames that have been released in prior periods, the primary evaluation criterion is actual title performance. For videogames that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific videogame to which the royalties relate. Criteria used to evaluate expected game performance include: historical performance of comparable videogames developed with comparable technology; orders for the videogame prior to its release; and, for any videogame sequel, estimated performance based on the performance of the videogame on which the sequel is based.

 
25

 

Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized royalty costs. In evaluating the recoverability of capitalized royalty costs, the assessment of expected videogame performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual videogame sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.
 
Intellectual Property Licenses. Intellectual property license costs consist of fees paid by us to license the use of trademarks, copyrights, and software used in the development of videogames. Depending on the agreement, we may use acquired intellectual property in multiple videogames over multiple years or for a single videogame. When no significant performance remains with the licensor upon execution of the license agreement, we record an asset and a liability at the contractual amount. We believe that the contractual amount represents the fair value of the liability. When significant performance remains with the licensor, we record the payments as an asset when paid to the licensee and as a liability upon achievement of certain contractual milestones rather than upon execution of the agreement. We classify these obligations as current liabilities to the extent they are contractually due within the next 12 months. Capitalized intellectual property license costs for those videogames that are cancelled or abandoned are charged to “cost of goods sold - intellectual property licenses” in the period of cancellation.
 
Beginning upon the related videogame’s release, capitalized intellectual property license costs are amortized to “cost of sales - intellectual property licenses” based on the greater of: (1) the ratio of current revenues for the specific videogame to total projected revenues for all videogames in which the licensed property will be utilized or (2) the straight-line amortization based on the useful lives of the asset. As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year.
 
We evaluate the future recoverability of capitalized intellectual property license costs on a quarterly basis. For videogames that have been released in prior periods, the primary evaluation criterion is actual title performance. For videogames that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific videogames to which the costs relate or in which the licensed trademark or copyright is to be used. Criteria used to evaluate expected game performance include: historical performance of comparable videogames developed with comparable technology; orders for the game prior to its release; and, for any videogame sequel, estimated performance based on the performance of the videogame on which the sequel is based. Further, as intellectual property licenses may extend for multiple videogames over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors, such as the success of other products and/or entertainment vehicles utilizing the intellectual property and the holder’s right to continued promotion and exploitation of the intellectual property.
 
Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized intellectual property license costs. In evaluating the recoverability of capitalized intellectual property license costs, the assessment of expected game performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual videogame sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.
 
Revenue Recognition.  We recognize revenues from the sale of our videogames upon the transfer of title and risk of loss to the customer.   Accordingly, we recognize revenues for software titles when (1) there is persuasive evidence that an arrangement with the customer exists, which is generally a purchase order, (2) the product is delivered, (3) the selling price is fixed or determinable, and (4) collection of the customer receivable is deemed probable. Our payment arrangements with customers typically provide for net 30 and 60 day terms. Advances received for licensing and exclusivity arrangements are reported on the consolidated balance sheets as deferred revenues until we meet our performance obligations, at which point the revenues are recognized. Revenue is recognized after deducting estimated reserves for returns, price protection and other allowances. In circumstances when we do not have a reliable basis to estimate returns and price protection or we are unable to determine that collection of a receivable is probable, we defer the revenue until such time as we can reliably estimate any related returns and allowances and determine that collection of the receivable is probable.
 
Some of our videogames provide limited online features at no additional cost to the consumer. Generally, we consider such features to be incidental to the overall product offering and an inconsequential deliverable. Accordingly, we recognize revenue related to videogames containing these limited online features upon the transfer of title and risk of loss to our customer. In instances where online features or additional functionality are considered a substantive deliverable in addition to the videogame, we take this into account when applying our revenue recognition policy. This evaluation is performed for each videogame together with any online transactions, such as electronic downloads or videogame add-ons when it is released. When we determine that a videogame contains online functionality that constitutes a more-than-inconsequential separate service deliverable in addition to the videogame, principally because of its importance to game play, we consider that our performance obligations for this game extend beyond the delivery of the game. Fair value does not exist for the online functionality, as we do not separately charge for this component of the videogame. As a result, we recognize all of the revenue from the sale of the game upon the delivery of the remaining online functionality. In addition, we defer the costs of sales for this game and recognize the costs upon delivery of the remaining online functionality.

 
26

 

With respect to online transactions, such as electronic downloads of games or add-ons that do not include a more-than-inconsequential separate service deliverable, revenue is recognized when the fee is paid by the online customer to purchase online content and we are notified by the online retailer that the product has been downloaded. In addition, persuasive evidence of an arrangement must exist, collection of the related receivable must be probable and the fee must be fixed and determinable.
 
Third-party licensees in Europe distribute Gamecock’s videogames under license agreements with Gamecock. The licensees paid certain minimum, non-refundable, guaranteed royalties when entering into the licensing agreements. Upon receipt of the advances, we defer their recognition and recognize the revenues in subsequent periods as these advances are earned by us. As the licensees pay additional royalties above and beyond those initially advanced, we recognize these additional royalties as revenues when earned.
 
With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of a master copy. Per copy royalties on sales that exceed the guarantee are recognized as earned. In addition, persuasive evidence of an arrangement must exist, collection of the related receivable must be probable, and the fee must be fixed and determinable.
 
Stock-Based Compensation. We estimate the fair value of stock-based payment awards on the measurement date using the Black-Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations.
 
Stock-based compensation expense recognized in the consolidated statements of operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. Stock compensation guidance requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
 
We account for equity instruments issued to non-employees in accordance with FASB guidance surrounding stock compensation and equity-based payment for non-employees.
 
We estimate the value of employee, non-employee director and non-employee stock options on the date of grant using the Black-Scholes option pricing model. Our determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.
 
Business Combinations. We estimate the fair value of assets acquired, and liabilities assumed in a business combination. Our assessment of the estimated fair value of each of these can have a material effect on our reported results as intangible assets are amortized over various lives. Furthermore, a change in the estimated fair value of an asset or liability often has a direct impact on the amount to recognize as goodwill, an asset that is not amortized. Often determining the fair value of these assets and liabilities assumed requires an assessment of expected use of the asset, the expected future cash flows related to the asset, and the expected cost to extinguish the liability. Such estimates are inherently difficult and subjective and can have a material impact on our financial statements.
 
Assessment of Impairment of Goodwill. Current accounting standards provide for a two-step approach to testing goodwill for impairment, which must be performed at least annually by applying a fair-value-based test. The first step measures for impairment by applying fair-value-based tests. The second step (if necessary) measures the amount of impairment by applying fair-value-based tests to the individual assets and liabilities.
 
To determine the fair values of the reporting units used in the first step, we use a combination of the market approach, which utilizes comparable companies’ data and/or the income approach, or discounted cash flows. Each step requires us to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include long-term growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates based on our weighted average cost of capital, future economic and market conditions and determination of appropriate market comparables. These estimates and assumptions have to be made for each reporting unit evaluated for impairment. Our estimates for market growth, our market share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying business. Our business consists of publishing and distributing interactive entertainment software and content using both established and emerging intellectual properties and our forecasts for emerging intellectual properties are based upon internal estimates and external sources rather than historical information and have an inherently higher risk of accuracy. If future forecasts are revised, they may indicate or require future impairment charges. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.

 
27

 

Consolidated Results of Operations
 
The following table sets forth our results of operations expressed as a percentage of net revenues for the three months ended September 30, 2009 and 2008:
 
   
Three Months Ended
September 30,
 
   
2009
   
2008
 
             
Net revenues
   
100.0
%
   
100.0
%
                 
Cost of goods sold:
               
Product costs
   
21.2
%
   
64.7
%
Royalties
   
29.9
%
   
9.6
%
Intellectual property licenses
   
0.7
%
   
0.5
%
Total cost of goods sold
   
51.9
%
   
74.9
%
                 
Gross profit
   
48.1
%
   
25.1
%
                 
Operating expenses: 
               
Warehousing and distribution
   
1.7
%
   
2.5
%
Sales and marketing
   
21.9
%
   
23.8
%
Transaction costs
   
-
     
0.2
%
General and administrative
   
18.6
%
   
16.5
%
Total operating expenses
   
42.2
%
   
42.9
%
                 
Income (loss) from operations
   
5.9
%
   
(17.8
)%
                 
Interest expense, net
   
1.8
%
   
0.7
%
                 
Net income (loss)
   
4.1
%
   
(18.5
)%
                 
Deemed dividend related to beneficial conversion feature on Series A convertible preferred stock
   
-
     
13.6
%
Net income (loss) attributable to common shareholders
   
4.1
%
   
(32.1
)%
 
Three Months Ended September 30, 2009 and 2008
 
Net Revenues. Net revenues for the three months ended September 30, 2009 were $16,709,649, an increase of $8,321,946, or 99%, from net revenues of $8,387,703 for the three months ended September 30, 2008. The increase in net revenues was primarily driven by releasing an increased number of titles.  For the three months ended September 30, 2009, the number of videogame units sold increased to approximately 737,000, an increase of 207,000 units from the units sold in the prior period. Average net revenue per videogame unit sold increased 43%, from $15.83 to $22.67 for the three months ended September 30, 2008 and 2009, respectively. This average increase in price is mainly due to selling more units for next generation platforms, which have a higher MSRP, in the three months ended September 30, 2009 versus the prior period.
 
Cost of Goods Sold. Cost of goods sold for the three months ended September 30, 2009 increased to $8,667,017, up $2,388,563, or 38%, from $6,278,454 for the prior period. The cost of royalty expense for the three months ended September 30, 2009 was $5,000,671, an increase of 518%, from royalty expense of $808,921 for the three months ended September 30, 2008.  This increase is attributable to an increase in developer royalty agreements associated with the increased number of titles released during the period.

 
28

 

Gross Profit. For the three months ended September 30, 2009 and 2008, gross profit increased to $8,042,632 from $2,109,249, or 281%, and gross profit margin increased to approximately 48% from 25%. The increase in gross profit is attributed to selling more units for next generation platforms, which have a higher MSRP, in the three months ended September 30, 2009 versus the prior period.
 
Warehousing and Distribution Expenses. For the three months ended September 30, 2009 and 2008, warehousing and distribution expenses were $286,511 and $207,583, respectively, resulting in an increase of 38%. This increase is due primarily to the increase in the number of units shipped from 530,000 during the three months ended September 30, 2008 to 737,000 during the three months ended September 30, 2009.
   
Sales and Marketing Expenses. For the three months ended September 30, 2009, sales and marketing expenses increased 83% to $3,655,056 from $1,995,736 for the three months ended September 30, 2008. This increase is primarily due to increased marketing budgets relating to the launch of two Xbox 360 titles released in the quarter, Section 8 and Raven Squad and continued marketing for the My Baby brand.  Sales and marketing costs vary on a videogame by videogame basis depending on market conditions and consumer demand, and do not necessarily increase or decrease proportionate to sales volumes. Included in sales and marketing expenses for the three months ended September 30, 2009 and 2008 is a non-cash charge of $27,622 and $37,734, respectively, for stock options granted to vendors and other non-employees.
   
General and Administrative Expenses. For the three months ended September 30, 2009, general and administrative expenses increased 126% to $3,114,768 from $1,380,425 for the prior period. The increase in general and administrative expenses was primarily due to wages of $939,619, professional fees of $1,277,847 and a non-cash charge of $128,574 related to employee stock options and restricted stock. Travel and entertainment expenses were $87,120 for the three months ended September 30, 2008, as compared to $53,323 for the three months ended September 30, 2009. General and administrative expenses as a percentage of net revenues increased, to approximately 19% for the three months ended September 30, 2009 from 17% for the prior period.
 
Transaction Costs. For the three months ended September 30, 2008, we incurred $18,380 in costs related to the reverse acquisition. These costs included professional fees to accounting firms, law firms and advisors.
 
Operating Income/Loss. For the three months ended September 30, 2009, our operating income was $986,297, as compared to an operating loss of $1,492,875 for the prior period.
 
Interest and Financing Costs. For the three months ended September 30, 2009, interest and financing costs increased to $299,316 from $58,879 for the prior period due to an increase in average borrowings as a result of the increase in our accounts receivable and a decrease in working capital resulting from the full deployment of the proceeds we received from the sale of Series A convertible preferred stock in fiscal years 2009 and 2008. The increase is also attributable to expense related to the production advance payable.
 
Net Income/Loss. For the three months ended September 30, 2009, our net income was $686,981, as compared to a net loss of $1,551,754 for the prior period.
 
Quarterly Operating Results Not Meaningful
 
Our quarterly net revenues and operating results have varied widely in the past and can be expected to vary in the future due to numerous factors, several of which are not under our control. These factors include the timing of our release of new titles, the popularity of both new titles and titles released in prior periods, changes in the mix of titles with varying gross margins, the timing of customer orders, and fluctuations in consumer demand for gaming platforms. Accordingly, our management believes that quarter-to-quarter comparisons of our operating results are not meaningful.
 
Liquidity and Capital Resources
 
Our primary cash requirements have been to fund (i) the development, manufacturing and marketing of our videogames, (ii) working capital, and (iii) capital expenditures. Historically, we have met our capital needs through our operating activities, our line of credit, through the sale of our equity securities, and, prior to the reverse acquisition, loans from related parties and our shareholders. Our cash and cash equivalents were $273,481 at September 30, 2009 and $648,311 at June 30, 2009.
 
Line of Credit. We have a line of credit with a financial institution, which comes due on November 30, 2009 and is currently in the process of being renewed. The line of credit bears interest at prime plus ½%, which was 3.75% at September 30, 2009. Availability under the line of credit is restricted to 65% of our eligible accounts receivable plus $500,000. The line of credit is primarily secured by our accounts receivable. The line of credit is further secured by the personal guarantees and pledge of personal securities and assets, of two of our shareholders and certain of their affiliates. At September 30, 2009, we were in compliance with all of the line of credit’s covenants and requirements.

 
29

 

At September 30, 2009 and June 30, 2009, the outstanding line of credit balance was $7,123,865 and $5,349,953, respectively, and the remaining available under the line of credit amounted to $876,135 and  $-0-, respectively.
 
Account Receivable. Generally, we have been able to collect our accounts receivable in the ordinary course of business. We do not hold any collateral to secure payment from customers. We are subject to credit risks, particularly if any of our accounts receivable represent a limited number of customers. If we are unable to collect our accounts receivable as they become due, it could adversely affect our liquidity and working capital position.
 
At September 30, 2009 and June 30, 2009, amounts due from our three largest customers comprised approximately 45% and 52% of our gross accounts receivable balance, respectively. We believe that the receivable balances from these largest customers do not represent a significant credit risk based on past collection experience, although we actively monitor each customer’s credit worthiness and economic conditions that may impact our customers’ business and access to capital. We are monitoring the current turmoil in the economy, the global contraction of current credit and other factors as they relate to our customers in order to manage the risk of uncollectible accounts receivable.
 
Preferred Stock. During the fourth quarter of fiscal year 2008 and the first half of fiscal year 2009, we sold 14,563,833 shares of preferred stock valued at $14,563,833, which provided additional liquidity to fund our continued growth through investment in videogame development.
 
Although there can be no assurance, we believe our current cash and cash equivalents and projected cash flow from operations, along with availability under our line of credit, will provide us with sufficient liquidity to satisfy our cash requirements for working capital, capital expenditures and commitments through at least the next 12 months. In addition, if we were to become unable to fully fund our cash requirements through current cash and cash equivalents and projected cash flow from operations, we would need to obtain additional financing through a combination of equity and debt financings. If any such activities become necessary, there can be no assurance that we would be successful in obtaining additional financing, particularly in light of the general economic downturn.
 
Cash Flows. We expect that we will make significant expenditures relating to advances on royalties to third-party developers to fund our continued growth. Cash flows from operations are affected by our ability to release successful titles. Though many of these titles have substantial royalty advances and marketing expenditures, once a title recovers these costs, incremental net revenues typically will directly and positively impact cash flows.
 
For the three months ended September 30, 2009 and 2008, we had net cash used in operating activities of $2,221,544 and $1,826,090, respectively.
 
During the three months ended September 30, 2009, investing activities resulted in net cash provided of $391,183 and during the three months ended September 30, 2008, investing activities resulted in net cash used of $120,433. The cash provided was a result of the increase in restricted cash during the three months ended September 30, 2009.
 
During the three months ended September 30, 2009, financing activities resulted in net cash provided of $1,406,774 and during the three months ended September 30, 2008, financing activities resulted in net cash used of $996,472.
 
As our gross profit margins increase, our operating cash flows are expected to contribute more towards our capital needs in the future. The Gamecock Acquisition caused a short-term strain on our cash flows, as we needed to fund the payment of certain liabilities Gamecock incurred prior to the Gamecock Acquisition. This short-term strain on cash flows limited our ability to fund additional production of a successful videogame. As a result, our Chairman, Terry Phillips, advanced $307,440 to us in order to fund the production of additional cartridges for a particular videogame. The advance was unsecured, payable on demand and non-interest bearing.  At June 30, 2009, the amount due was $232,440.  Subsequent to June 30, 2009, the amount was repaid.
 
International Operations. Net revenue earned outside of North America is principally generated by our operations in Europe, Australia and Asia. For the three months ended September 30, 2009 and 2008, approximately 28% and 11%, respectively, of our net revenue was earned outside of the U.S. We are subject to risks inherent in foreign trade, including increased credit risks, tariffs and duties, fluctuations in foreign currency exchange rates, shipping delays and international political, regulatory and economic developments, all of which can have a significant impact on our operating results.

 
30

 

Item 3.  Quantitative and Qualitative Disclosures about Market Risk
 
For quantitative and qualitative disclosures about market risk, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of our annual report on Form 10-K for the year ended June 30, 2009. Our exposures to market risk have not changed materially since June 30, 2009.
 
Item 4T. Controls and Procedures
 
Restatement of Previously Issued Financial Statements
 
In connection with the filing of our Form 10-Q/A with the SEC on September 11, 2009, during the first fiscal quarter of 2010, management reevaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based on that reevaluation, the Chief Executive Officer, who is also serving as our interim Chief Financial Officer, and in consultation with our Chairman, concluded that the our disclosure controls and procedures were not effective as of March 31, 2009 as a result of the following material weaknesses in our internal control over financial reporting.
 
 
·
There were material operational deficiencies related to the preparation and review of financial information during our quarter end closing process.  These items resulted in more than a remote likelihood that a material misstatement or lack of disclosure within our interim financial statements would not be prevented or detected.  Our senior financial management lacked the necessary experience and we did not maintain a sufficient number of qualified personnel to support our financial reporting and close process. This reduced the likelihood that such individuals could detect a material adjustment to our books and records or anticipate, identify, and resolve accounting issues in the normal course of performing their assigned functions.  This material weakness resulted in adjustments to inventories, accounts payable, accrued royalties, accrued expenses and other current liabilities, due to shareholders, additional paid-in capital, product costs, royalties, sales and marketing and general and administrative expenses in our condensed consolidated financial statements for the three and nine month periods ended March 31, 2009.
 
 
·
There were material operational deficiencies in our controls over related party transactions which resulted in a more than remote likelihood that a material misstatement or lack of disclosure in our interim financial statements would not be prevented or detected.  Management determined that established controls over related party transactions were not consistently applied to all related party transactions. This inconsistent application led to breakdowns in communication between management and our accounting department and resulted in an increased likelihood that the accounting department would not detect a significant transaction affecting us, which would lead to a material adjustment to our books and records or a material change to the disclosure in the footnotes to our interim financial statements. This material weakness resulted in adjustments to inventories, due to shareholders, and product costs in our condensed consolidated financial statements for the three and nine month periods ended March 31, 2009.
 
 
·
There were material internal control and operational deficiencies related to the maintenance of our accruals and related expense accounts.  These items resulted in more than a remote likelihood that a material misstatement or lack of disclosure within our interim financial statements would not be prevented or detected.  Specifically, effective controls were not designed and in place to ensure the completeness, accuracy and timeliness of the recording of accruals for services provided and not billed at period end. This increased the likelihood that our accruals would be materially understated.  This material weakness resulted in adjustments to accounts payable, accrued royalties, accrued expenses and other current liabilities, product costs, royalties, sales and marketing and general and administrative expenses in our condensed consolidated financial statements for the three and nine month periods ended March 31, 2009.
 
 
·
There were material internal control and operational deficiencies related to our reconciliation of inventory liability clearing accounts.  This item resulted in more than a remote likelihood that a material misstatement or lack of disclosure within our interim financial statements would not be prevented or detected.  Specifically, our account reconciliations, analyses and review procedures were ineffective as they lacked independent and timely review and separate review and approval of journal entries related to these accounts.  This material weakness resulted in adjustments to inventories in our condensed consolidated financial statements for the three and nine month periods ended March 31, 2009.
 
Evaluation of Disclosure Controls and Procedures
 
An evaluation was carried out under the supervision and with the participation of our management, including our Chief Executive Officer, who is also serving as our interim Chief Financial Officer, and in consultation with our Chairman and our interim Chief Accounting Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, to ensure that the information required to be disclosed by us in this quarterly report was recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and Form 10-Q and that such information required to be disclosed was accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure.  Based upon this reevaluation, our Chief Executive Officer, who is also serving as our interim Chief Financial Officer, concluded that our disclosure controls and procedures were not effective as of September 30, 2009 as a result of the previously identified material weaknesses in our internal control over financial reporting.

 
31

 

In connection with the preparation of our annual report on Form 10-K for the year ended June 30, 2009, under the supervision and with the participation of management, including our Chief Executive Officer, who is also serving as our interim Chief Financial Officer, and in consultation with our Chairman and our interim Chief Accounting Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in “Internal Control — Integrated Framework”, our management concluded that our internal control over financial reporting was not effective as of June 30, 2009 as a result of the previously identified material weaknesses.
 
Changes in Internal Control over Financial Reporting
 
As discussed above, as of June 30, 2009, we had material weaknesses in our internal control over financial reporting.
 
In addition to the remediation measures described below under the heading “Remediation Steps to Address Material Weakness,” we have made the following changes to address the previously reported material weaknesses in internal control over financial reporting and disclosure controls and procedures:
 
 
·
we implemented a closing calendar and consolidation process that includes accrual based financial statements being reviewed by qualified personnel in a timely manner;
 
 
·
we review consolidating financial statements with senior management and the audit committee of the board of directors; and
 
 
·
we complete disclosure checklists for both GAAP and SEC required disclosures to ensure disclosures are complete.
 
Remediation Steps to Address Material Weakness
 
Beginning in the first fiscal quarter of 2010, we began the process of remediating the material weaknesses described above and enhancing our internal control over financial reporting.  In connection with our remediation process, we have taken the following remediation measures:
 
 
·
we have hired an interim Chief Accounting Officer with the requisite experience in internal accounting in the videogame industry and made other related personnel changes;
 
 
·
we have provided training to our management and accounting personnel regarding established controls and procedures for related party transactions; and
 
 
·
we have enhanced our computer software and internal procedures related to information technology in order to migrate from spreadsheet applications into automated functions within the accounting system.
 
Additionally, in connection with our remediation process we are implementing the following remediation measures:
 
 
·
we are developing additional training for our accounting personnel and reallocating duties of certain accounting personnel;
 
 
·
we are implementing access controls into our financial accounting software;
 
 
·
we are enhancing procedures and documentation supporting our accruals;
 
 
·
we are beginning an internal communication program with our employees regarding ethics and the availability of our internal fraud hotline; and
 
 
·
we are incorporating more robust management review of our general and administrative expense accruals.
 
Management anticipates that the actions described above and the resulting improvements in controls will strengthen its internal control over financial reporting relating to the preparation of the condensed consolidated financial statements and will remediate the material weakness identified by the end of our fiscal year 2010.  As we improve our internal control over financial reporting and implement remediation measures, we may supplement or modify the remediation measures described above.  Management is committed to implementing effective control policies and procedures and will continually update our Audit Committee as to the progress and status of our remediation efforts to ensure that they are adequately implemented.

 
32

 

PART II
 
Item 1.  Legal Proceedings
 
On March 12, 2009, we, along with Gamecock, SouthPeak Interactive, Ltd. and Gamecock Media Europe, Ltd., were served with a complaint by CDV Software Entertainment A.G., or CDV, alleging various breach of contract and other claims related to a publishing and distribution agreement, or the Distribution Agreement, entered into between Gamecock Media Europe, Ltd. and CDV in January 2008. CDV is seeking the return of $4,590,000 in videogame development advances, an injunction against us and our subsidiaries, approximately $650,000 in specified damages, further damages to be assessed, and discretionary interest and costs. Gamecock Media Europe, Ltd. filed a counterclaim against CDV for $950,000 and discretionary interest and costs, resulting from videogame sales and the achievement of a milestone under the Distribution Agreement. The hearing for both CDV’s claims and Gamecock Media Europe’s counterclaim concluded on July 22, 2009, and the court is expected to issue its ruling in the near future.
 
On October 27, 2008, Gamecock was served with a demand for arbitration by a developer alleging various breaches of contract related to a publishing agreement entered into between Gamecock and the developer on December 12, 2007. The developer is seeking an award of $4,910,000, termination of the agreement, exclusive control of the subject videogame, and discretionary interest and costs. Gamecock has responded stating that the developer’s attempts to terminate the publishing Agreement constitute wrongful termination of the agreement and breach of the agreement. Gamecock has also filed a counterclaim against the developer seeking the return of approximately $5.9 million in advances on royalties in the event the publishing agreement is terminated.  The developer has filed a supplemental demand for arbitration concerning royalty payments due under a separate publishing agreement and is seeking an award of $41,084.  The arbitration hearing has been scheduled for January 2010.  As of September 30, 2009, no amounts have been accrued related to this matter.
 
Other than the foregoing, we are not currently subject to any material legal proceedings. From time to time, however, we are named as a defendant in legal actions arising from our normal business activities. Although we cannot accurately predict the amount of our liability, if any, that could arise with respect to legal actions currently pending against us, we do not expect that any such liability will have a material adverse effect on our consolidated financial position, operating results or cash flows. We believe that we have obtained adequate insurance coverage, rights to indemnification, or where appropriate, have established reserves in connection with these legal proceedings.
 
Item 1A.  Risk Factors
 
“Item 1A. Risk Factors” of our annual report on Form 10-K for the year ended June 30, 2009 includes a discussion of our risk factors.  There have been no material changes to risk factors as previously disclosed in our annual report on Form 10-K filed with the Securities and Exchange Commission on October 13, 2009.
 
Item 6.  Exhibits
 
Exhibit
   
Number
 
Exhibit
     
3.1(1)
 
Amended and Restated Certificate of Incorporation.<