Attached files

file filename
EX-32.2 - EXHIBIT 32.2 CFO 906 Q3-17 - REALNETWORKS INCexhibit322-10q2017q3.htm
EX-32.1 - EXHIBIT 32.1 CEO 906-Q3-17 - REALNETWORKS INCexhibit321-10q2017q3.htm
EX-31.2 - EXHIBIT 31.2 CFO 302 Q3-17 - REALNETWORKS INCexhibit312-10q2017q3.htm
EX-31.1 - EXHIBIT 31.1 CEO 302 Q3-17 - REALNETWORKS INCexhibit311-10q2017q3.htm



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2017
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission file number 0-23137
 
 RealNetworks, Inc.
 
 
(Exact name of registrant as specified in its charter)
 
Washington
 
91-1628146
(State of incorporation)
 
(I.R.S. Employer
Identification Number)
1501 First Avenue South, Suite 600
Seattle, Washington
 
98134
(Address of principal executive offices)
 
(Zip Code)
 
(206) 674-2700
 
 
(Registrant’s telephone number, including area code)
 
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  ý    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  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
¨
  
Accelerated filer
ý
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
  
Smaller reporting company
¨
 
 
 
 
Emerging growth company
¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No   ý
The number of shares of the registrant’s Common Stock outstanding as of October 26, 2017 was 37,302,869.




TABLE OF CONTENTS
 

2



PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
 
September 30,
2017
 
December 31,
2016
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
45,597

 
$
33,721

Short-term investments
13,482

 
43,331

Trade accounts receivable, net of allowances
26,651

 
22,162

Deferred costs, current portion
508

 
760

Prepaid expenses and other current assets
4,558

 
4,910

Total current assets
90,796

 
104,884

Equipment, software, and leasehold improvements, at cost:
 
 
 
Equipment and software
45,557

 
46,231

Leasehold improvements
3,464

 
3,317

Total equipment, software, and leasehold improvements, at cost
49,021

 
49,548

Less accumulated depreciation and amortization
44,962

 
44,294

Net equipment, software, and leasehold improvements
4,059

 
5,254

Restricted cash equivalents and investments
2,400

 
2,700

Other assets
2,177

 
1,742

Deferred costs, non-current portion
1,010

 
1,246

Deferred tax assets, net
871

 
816

Other intangible assets, net
429

 
938

Goodwill
13,042

 
12,857

Total assets
$
114,784

 
$
130,437

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
18,560

 
$
18,225

Accrued and other current liabilities
12,933

 
15,425

Commitment to Rhapsody

 
1,500

Deferred revenue, current portion
3,008

 
3,430

Total current liabilities
34,501

 
38,580

Deferred revenue, non-current portion
553

 
240

Deferred rent
798

 
748

Deferred tax liabilities, net
98

 
87

Other long-term liabilities
1,651

 
2,201

Total liabilities
37,601

 
41,856

Commitments and contingencies

 

Shareholders’ equity:
 
 
 
Preferred stock, $0.001 par value, no shares issued and outstanding:
 
 
 
Series A: authorized 200 shares

 

Undesignated series: authorized 59,800 shares

 

Common stock, $0.001 par value authorized 250,000 shares; issued and outstanding 37,289 shares in 2017 and 37,501 shares in 2016
37

 
37

Additional paid-in capital
637,862

 
633,928

Accumulated other comprehensive loss
(59,833
)
 
(61,645
)
Retained deficit
(500,883
)
 
(483,739
)
Total shareholders’ equity
77,183

 
88,581

Total liabilities and shareholders’ equity
$
114,784

 
$
130,437

See accompanying notes to unaudited condensed consolidated financial statements.

3



REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
(In thousands, except per share data)
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Net revenue (A)
$
30,002

 
$
31,051

 
$
93,689

 
$
89,015

Cost of revenue (B)
16,534

 
16,740

 
51,117

 
47,610

Gross profit
13,468

 
14,311

 
42,572

 
41,405

Operating expenses:
 
 
 
 
 
 
 
Research and development
7,152

 
6,699

 
22,085

 
23,185

Sales and marketing
4,883

 
7,183

 
17,534

 
24,157

General and administrative
5,081

 
7,086

 
15,638

 
21,380

Restructuring and other charges
557

 
499

 
2,271

 
1,297

Lease exit and related charges

 
1,233

 

 
2,191

Total operating expenses
17,673

 
22,700

 
57,528

 
72,210

Operating income (loss)
(4,205
)
 
(8,389
)
 
(14,956
)
 
(30,805
)
Other income (expenses):
 
 
 
 
 
 
 
Interest income, net
116

 
119

 
353

 
316

Gain (loss) on investments, net

 
6,021

 

 
5,978

Equity in net loss of Rhapsody investment

 
(233
)
 
(1,097
)
 
(629
)
Other income (expense), net
(50
)
 
(243
)
 
(288
)
 
(515
)
Total other income (expenses), net
66

 
5,664

 
(1,032
)
 
5,150

Income (loss) before income taxes
(4,139
)
 
(2,725
)
 
(15,988
)
 
(25,655
)
Income tax expense (benefit)
195

 
331

 
1,156

 
919

Net income (loss)
$
(4,334
)
 
$
(3,056
)
 
$
(17,144
)
 
$
(26,574
)
 
 
 
 
 
 
 
 
Basic net income (loss) per share
$
(0.12
)
 
$
(0.08
)
 
$
(0.46
)
 
$
(0.72
)
Diluted net income (loss) per share
$
(0.12
)
 
$
(0.08
)
 
$
(0.46
)
 
$
(0.72
)
Shares used to compute basic net income (loss) per share
37,200

 
36,805

 
37,112

 
36,693

Shares used to compute diluted net income (loss) per share
37,200

 
36,805

 
37,112

 
36,693

 
 
 
 
 
 
 
 
Comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized investment holding gains (losses), net of reclassification adjustments
$

 
$
72

 
$
10

 
$
239

Foreign currency translation adjustments, net of reclassification adjustments
562

 
428

 
1,802

 
483

Total other comprehensive income (loss)
562

 
500

 
1,812

 
722

Net income (loss)
(4,334
)
 
(3,056
)
 
(17,144
)
 
(26,574
)
Comprehensive income (loss)
$
(3,772
)
 
$
(2,556
)
 
$
(15,332
)
 
$
(25,852
)
 
 
 
 
 
 
 
 
(A) Components of net revenue:
 
 
 
 
 
 
 
License fees
$
6,319

 
$
7,850

 
$
21,996

 
$
20,305

Service revenue
23,683

 
23,201

 
71,693

 
68,710

 
$
30,002

 
$
31,051

 
$
93,689

 
$
89,015

(B) Components of cost of revenue:
 
 
 
 
 
 
 
License fees
$
1,655

 
$
1,755

 
$
5,381

 
$
4,458

Service revenue
14,879

 
14,985

 
45,736

 
43,152

 
$
16,534

 
$
16,740

 
$
51,117

 
$
47,610

See accompanying notes to unaudited condensed consolidated financial statements.

4



REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
Nine Months Ended
September 30,
 
2017
 
2016
Cash flows from operating activities:
 
 
 
Net income (loss)
$
(17,144
)
 
$
(26,574
)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
2,402

 
5,897

Stock-based compensation
3,045

 
4,557

Equity in net loss of Rhapsody
1,097

 
629

Deferred income taxes, net
(55
)
 
(198
)
Loss (gain) on investments, net

 
(5,978
)
Realized translation loss (gain)

 
272

Fair value of warrants granted in 2015 and 2017, net of subsequent mark to market adjustments in 2017 and 2016
(367
)
 
112

Net change in certain operating assets and liabilities:
 
 
 
Trade accounts receivable
(3,516
)
 
(1,744
)
Prepaid expenses and other assets
1,072

 
1,155

Accounts payable
(447
)
 
450

Accrued and other liabilities
(3,630
)
 
(872
)
Net cash provided by (used in) operating activities
(17,543
)
 
(22,294
)
Cash flows from investing activities:
 
 
 
Purchases of equipment, software, and leasehold improvements
(541
)
 
(2,009
)
Proceeds from sale of equity and other investments

 
2,110

Purchases of short-term investments
(13,905
)
 
(59,124
)
Proceeds from sales and maturities of short-term investments
43,754

 
68,473

Decrease (increase) in restricted cash equivalents and investments, net
300

 
190

Acquisitions

 
(150
)
Advance to Rhapsody
(1,500
)
 

Proceeds from the sale of Slingo and social casino business

 
4,000

Net cash provided by (used in) investing activities
28,108

 
13,490

Cash flows from financing activities:
 
 
 
Proceeds from issuance of common stock (stock options and stock purchase plan)
130

 
166

Tax payments from shares withheld upon vesting of restricted stock
(338
)
 
(843
)
Net cash provided by (used in) financing activities
(208
)
 
(677
)
Effect of exchange rate changes on cash and cash equivalents
1,519

 
450

Net increase (decrease) in cash and cash equivalents
11,876

 
(9,031
)
Cash and cash equivalents, beginning of period
33,721

 
47,315

Cash and cash equivalents, end of period
$
45,597

 
$
38,284

 
 
 
 
Supplemental disclosure of cash flow information:
 
 
 
Cash received from income tax refunds
$
419

 
$
531

Cash paid for income taxes
$
1,124

 
$
1,876

Non-cash investing activities:
 
 
 
Increase (decrease) in accrued purchases of equipment, software, and leasehold improvements
$
42

 
$
(6
)
See accompanying notes to unaudited condensed consolidated financial statements.


5



REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Quarters and Nine Months Ended September 30, 2017 and 2016
Note 1
Description of Business and Summary of Significant Accounting Policies
Description of Business. RealNetworks, Inc. and subsidiaries is a global provider of network-delivered digital media applications and services that make it easy to manage, play and share digital media. The Company also develops and markets software products and services that enable the creation, distribution and consumption of digital media, including audio and video.
Inherent in our business are various risks and uncertainties, including a limited history of certain of our product and service offerings. RealNetworks' success will depend on the acceptance of our technology, products and services and the ability to generate related revenue.
In this Quarterly Report on Form 10-Q (10-Q or Report), RealNetworks, Inc. and Subsidiaries is referred to as “RealNetworks”, the “Company”, “we”, “us”, or “our”. "RealPlayer®" and other trademarks of ours appearing in this report are our property.
Basis of Presentation. The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany balances and transactions have been eliminated in consolidation.
The unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for any subsequent period or for the year ending December 31, 2017. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC).
These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2016 (the 10-K).
Use of Estimates. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Note 2
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (FASB) issued new revenue recognition guidance, which was subsequently updated and amended in 2015 and 2016. The guidance requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The new guidance will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective.
The guidance permits two methods of adoption: the full retrospective method where the standard would be applied to each prior reporting period presented and the cumulative effect of applying the standard would be recognized at the earliest period shown, or the modified retrospective method, where the cumulative effect of applying the standard would be recognized at the date of initial application. We will adopt the requirements of the new standard effective January 1, 2018, and will use the modified retrospective transition method with the cumulative effect to the opening balance of retained earnings recognized as of the date of initial adoption.
Our evaluation of the new standard has made significant progress, and we continue to monitor any authoritative and interpretive guidance issued by standard-setting bodies for impacts on our evaluations. Under the new standard, we currently expect the greatest impact in certain areas where we will be required to estimate usage which drives the underlying revenue. Under the current guidance, we do not recognize revenues until we achieve fixed and determinable status, which would typically be at a later date. We also expect an impact related to the licensing of our RealTimes and RealPlayer products. As we transition to the new revenue standard, we will recognize the revenue predominantly at the time of delivery rather than over the contract period. Revenue recognition for all other product lines is not expected to be significantly impacted.

6



As a result of the new standard, based on currently executed contracts, we may be required to record a cumulative adjustment increasing our Retained Earnings on January 1, 2018. We expect that the new standard will not have a cash impact and will not affect the economics of the underlying customer contracts. We expect that our disclosures in our notes to the Consolidated Financial Statements related to revenue recognition will be significantly expanded under the new standard, specifically around the quantitative and qualitative information about our underlying performance obligations. Our assessment of impacts resulting from the new standard is substantially complete and we are in the process of finalizing our conclusions and evaluating the quantitative impact of these conclusions in both recognition and presentation in the related disclosures. We believe we are continuing to follow an appropriate timeline for proper recognition, presentation and disclosure upon adoption, including the related impacts to our internal controls.
In February 2016, the FASB issued new guidance related to the accounting for leases by lessees. A major change in the new guidance is that lessees will be required to present right-of-use assets and lease liabilities on the balance sheet. The new guidance will be effective for us on January 1, 2019. We will be evaluating the effect that the guidance will have on our consolidated financial statements and related disclosures.
In November 2016, the FASB issued guidance on the classification and presentation of changes in restricted cash on the statement of cash flows. This guidance is effective for interim and annual reporting for us on January 1, 2018. We do not expect the adoption of this guidance to have a material impact on our statement of cash flows.
In January 2017, the FASB issued new guidance simplifying the test for goodwill impairment. The new guidance eliminates Step 2 from the goodwill impairment test, instead requiring an entity to recognize a goodwill impairment charge for the amount by which the reporting unit's carrying amount exceeds the reporting unit's fair value. This guidance is effective for interim and annual goodwill impairment tests beginning on December 15, 2019, with early adoption permitted. We will be evaluating the impact of the guidance, but do not currently expect the adoption to have a material impact on our consolidated financial statements and related disclosures.
There have been no other recent accounting pronouncements or changes in accounting pronouncements to be implemented that are of significance or potential significance to RealNetworks.
Note 3
Stock-Based Compensation
Total stock-based compensation expense recognized in our unaudited condensed consolidated statements of operations and comprehensive income (loss) includes amounts related to stock options, restricted stock, and employee stock purchase plans and was as follows (in thousands):
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Total stock-based compensation expense
$
748

 
$
778

 
$
3,045

 
$
4,557

The fair value of options granted determined using the Black-Scholes model used the following weighted-average assumptions:
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Expected dividend yield
0
%
 
0
%
 
0
%
 
0
%
Risk-free interest rate
1.61
%
 
1.00
%
 
1.71
%
 
1.25
%
Expected life (years)
3.7

 
3.8

 
4.2

 
4.6

Volatility
34
%
 
32
%
 
35
%
 
35
%

The total stock-based compensation amounts for 2017 and 2016 disclosed above are recorded in their respective line items within operating expenses in the unaudited condensed consolidated statements of operations and comprehensive income (loss). Included in the expense for the nine months ended September 30, 2017 and 2016 was stock compensation expense recorded in the first quarter of 2017 and 2016 related to our 2016 and 2015 incentive bonuses paid in fully vested restricted stock units, which were authorized and granted in the first quarter of 2017 and 2016, respectively.


7



As of September 30, 2017, $3.9 million of total unrecognized compensation cost, net of estimated forfeitures, related to stock awards. The unrecognized compensation cost is expected to be recognized over a weighted-average period of approximately 2 years.

Note 4
Rhapsody Joint Venture
As of September 30, 2017 we owned approximately 42% of the issued and outstanding stock of Rhapsody and account for our investment using the equity method of accounting.
Rhapsody was initially formed in 2007 as a joint venture between RealNetworks and MTV Networks, a division of Viacom International Inc. (MTVN), to own and operate a business-to-consumer digital audio music service known as Rhapsody.
Following certain restructuring transactions effective March 31, 2010, we began accounting for our investment in Rhapsody using the equity method of accounting. As part of the 2010 restructuring transactions, RealNetworks contributed $18.0 million in cash, the Rhapsody brand and certain other assets, including content licenses, in exchange for shares of convertible preferred stock of Rhapsody, carrying a $10.0 million preference upon certain liquidation events.
We recorded our share of losses of Rhapsody of $0.0 million and $1.1 million for the quarter and nine months ended September 30, 2017; and $0.2 million and $0.6 million for the quarter and nine months ended September 30, 2016. Because of the $10.0 million liquidation preference on the preferred stock we hold in Rhapsody, under the equity method of accounting we did not record any share of Rhapsody losses that would reduce our carrying value of Rhapsody, which is impacted by Rhapsody equity transactions, below $10.0 million, until Rhapsody's book value was reduced below $10.0 million. This occurred in the first quarter of 2015. As of September 30, 2017, the carrying value of our Rhapsody equity investment was zero, as we do not have further commitment to provide future support to Rhapsody. Unless we commit to provide future financial support to Rhapsody, we do not record our share of Rhapsody losses that would reduce our carrying value of Rhapsody below zero, and instead we track those suspended losses separately.
In December 2016, RealNetworks entered into an agreement to loan up to $5 million to Rhapsody for general operating purposes, as did the other large owner of Rhapsody, Columbus Nova. In 2016, $3.5 million of the loan was made by each lender. In January 2017, the remaining $1.5 million commitment was funded by each lender. The loan is subordinate to all existing loans, and bears an interest a rate of 10% per annum, which accretes into the outstanding principal balance and will be due at the December 7, 2017 maturity date. Under the terms of the loan agreement between RealNetworks and Rhapsody, a default by Rhapsody under its agreements with other third party lenders that would entitle such parties to accelerate repayments with an aggregate value in excess of $1 million, would constitute a cross default of the RealNetworks and Columbus Nova loans. In that case, RealNetworks and Columbus Nova could elect to declare all outstanding obligations owed to us by Rhapsody to become immediately due and payable.
We recognized previously suspended losses up to the amount of the commitment at the time of signing the agreement in the fourth quarter of 2016, and, consequently, we do not have a receivable recorded related to this loan. As of the date of this report, we have no further commitments for additional fundings to Rhapsody.
In late March 2017, we were notified that Rhapsody would likely be in default of existing agreements with its third party lenders, which was confirmed in April 2017. We believe this default constitutes a cross default under the loan agreements between Rhapsody and RealNetworks and Rhapsody and Columbus Nova. The default with the third party lenders relates to Rhapsody missing a quarterly revenue target that included assumptions regarding the launch of a new product which Rhapsody subsequently determined not to launch, thus contributing to a revenue shortfall. In June 2017, Rhapsody obtained forbearance agreements from the third party lenders, pursuant to which (in general terms) the lenders agreed to forbear from exercising any remedies they have against Rhapsody relating to defaults existing at June 30, 2017.
In October 2017, Rhapsody entered into a financing agreement with a new third party, under which Rhapsody's wholly owned subsidiary will factor certain receivable in return for cash advances. Rhapsody applied the initial cash proceeds from this arrangement to pay in full and terminate all outstanding term loans with third party lenders and a portion of the amounts outstanding under a revolving credit facility.
The forbearance agreement entered into in June 2017 (as discussed above) has been further extended with the remaining third party lender through November 30, 2017, or until a new default event, whichever may occur first. As of the date of our filing, to our knowledge, Rhapsody has not incurred any such default events; and RealNetworks and Columbus Nova have not elected to declare all amounts outstanding under our loan agreements to be immediately due and payable.

8



Summarized financial information for Rhapsody, which represents 100% of their financial information, is as follows (in thousands): 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Net revenue
$
42,816

 
$
54,306

 
$
134,414

 
$
160,269

Gross profit
7,245

 
15,195

 
19,927

 
29,288

Net income (loss)
(627
)
 
1,632

 
(13,960
)
 
(11,421
)
Note 5
Fair Value Measurements
Items Measured at Fair Value on a Recurring Basis
The following table presents information about our financial assets that have been measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016, and indicates the fair value hierarchy of the valuation inputs utilized to determine such fair value (in thousands).

 
Fair Value Measurements as of
 
Amortized Cost as of
 
September 30, 2017
 
September 30, 2017
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
 
 
Cash
$
27,254

 
$

 
$

 
$
27,254

 
$
27,254

Money market funds
16,843

 

 

 
16,843

 
16,843

Corporate notes and bonds

 
1,500

 

 
1,500

 
1,500

Total cash and cash equivalents
44,097

 
1,500

 

 
45,597

 
45,597

Short-term investments:
 
 
 
 
 
 
 
 
 
Corporate notes and bonds

 
13,482

 

 
13,482

 
13,478

Total short-term investments

 
13,482

 

 
13,482

 
13,478

Restricted cash equivalents and investments

 
2,400

 

 
2,400

 
2,400

Warrants issued by Rhapsody (included in Other assets)

 

 
1,140

 
1,140

 

Total
$
44,097

 
$
17,382

 
$
1,140

 
$
62,619

 
$
61,475



 
Fair Value Measurements as of
 
Amortized Cost as of
 
December 31, 2016
 
December 31, 2016
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
 
 
Cash
$
32,585

 
$

 
$

 
$
32,585

 
$
32,585

Money market funds
136

 

 

 
136

 
136

Corporate notes and bonds

 
1,000

 

 
1,000

 
1,000

Total cash and cash equivalents
32,721

 
1,000

 

 
33,721

 
33,721

Short-term investments:
 
 
 
 
 
 
 
 
 
Corporate notes and bonds

 
43,331

 

 
43,331

 
43,343

Total short-term investments

 
43,331

 

 
43,331

 
43,343

Restricted cash equivalents and investments

 
2,700

 

 
2,700

 
2,700

Warrant issued by Rhapsody (included in Other assets)

 

 
773

 
773

 

Total
$
32,721

 
$
47,031

 
$
773

 
$
80,525

 
$
79,764

Restricted cash equivalents and investments as of September 30, 2017 and December 31, 2016 relate to cash pledged as collateral against letters of credit in connection with lease agreements.

9



Realized gains or losses on sales of short-term investment securities for the quarters and nine months ended September 30, 2017 and 2016 were not significant. Gross unrealized gains and gross unrealized losses on short-term investment securities as of September 30, 2017 and December 31, 2016 were also not significant.
Investments with remaining contractual maturities of five years or less are classified as short-term because the investments are marketable and highly liquid, and we have the ability to utilize them for current operations. Contractual maturities of short-term investments as of September 30, 2017 (in thousands):
 
 
Estimated
Fair Value
Within one year
$
11,969

Between one year and five years
1,513

Total short-term investments
$
13,482

In February 2015, Rhapsody issued warrants to purchase Rhapsody common shares to each of RealNetworks and Rhapsody's one other large stockholder, Columbus Nova. The warrants were issued as compensation for past services provided by RealNetworks and Columbus Nova, and both warrants covered the same number of underlying shares. The exercise price of the warrants was equal to the fair value of the underlying shares on the issuance date, and we used the Black-Scholes option-pricing model to calculate the fair value of the warrant, using an expected term of 5 years and expected volatility of 55%. On the date of issuance, we recognized and recorded the $1.2 million fair value of the warrant issued to RealNetworks within Other assets in the unaudited condensed consolidated balance sheets, and as an expense reduction within General and administrative expense in the unaudited condensed consolidated statements of operations. The warrants are free-standing derivatives and as such their fair value is determined each quarter using updated inputs in the Black-Scholes option-pricing model. During the nine months ended September 30, 2017, the decrease in the fair value of the warrants was $0.1 million.
In February 2017, Rhapsody issued additional warrants to purchase Rhapsody common shares to both RealNetworks and Columbus Nova. Consistent with the warrants issued in 2015, the 2017 warrants were issued as compensation for past services provided by RealNetworks and Columbus Nova, and both warrants covered the same number of underlying shares. The exercise price of the warrants exceeded the fair value of the underlying shares on the issuance date, and we used the Black-Scholes option-pricing model to calculate the fair value of the warrant, using an expected term of 5 years and expected volatility of 55%, resulting in a recognized fair value of $0.5 million in Other assets in the unaudited condensed consolidated balance sheets, and as an expense reduction within general and administrative expense in the unaudited condensed consolidated statements of operations. During the nine months ended September 30, 2017, the decrease in the fair value of the warrants was insignificant.
Items Measured at Fair Value on a Non-recurring Basis
Certain of our assets and liabilities are measured at estimated fair value on a non-recurring basis, using Level 3 inputs. These instruments are subject to fair value adjustments only in certain circumstances (for example, when there is evidence of impairment). During the nine months ended September 30, 2017 and 2016, we did not record any impairments on those assets required to be measured at fair value on a non-recurring basis.

See Note 11, Lease Exit and Related Charges, for a discussion of the losses related to reductions in the use of RealNetworks' office space, which were recorded at the estimated fair value of remaining lease obligations, less expected sub-lease income.

10



Note 6
Allowance for Doubtful Accounts Receivable and Sales Returns
Activity in the allowance for doubtful accounts receivable and sales returns (in thousands):
 
 
Allowance For
 
Doubtful
Accounts
Receivable
 
Sales
Returns
Balances, December 31, 2016
$
633

 
$
169

Addition (reduction) to allowance
(19
)
 
13

Amounts written off

 
(11
)
Foreign currency translation
73

 
(1
)
Balances, September 30, 2017
$
687

 
$
170

Our low-margin music on demand customer, LOEN Entertainment, Co, Ltd. (LOEN), accounted for 63% of trade accounts receivable as of September 30, 2017. At December 31, 2016, the same customer accounted for 64% of trade accounts receivable.
LOEN accounted for 38% or $11.4 million of consolidated revenue during the quarter ended September 30, 2017, and 36% or $33.8 million during the nine months ended September 30, 2017, which is reflected in our Mobile Services segment.
LOEN accounted for 32% of consolidated revenue or $9.9 million during the quarter ended September 30, 2016 and 31% or $27.9 million during the nine months ended September 30, 2016, which is reflected in our Mobile Services segment.
Note 7
Other Intangible Assets
Other intangible assets (in thousands):
 
 
 
 
September 30, 2017
 
December 31, 2016
 
 
 
Gross
Amount
 
Accumulated
Amortization
 
Net
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amortizing intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Customer relationships
 
$
30,810

 
$
30,452

 
$
358

 
$
29,308

 
$
28,781

 
$
527

 
Developed technology
 
24,440

 
24,422

 
18

 
23,574

 
23,263

 
311

 
Patents, trademarks and tradenames
 
3,758

 
3,705

 
53

 
3,530

 
3,430

 
100

 
Service contracts
 
5,413

 
5,413

 

 
5,205

 
5,205

 

 
Total
 
$
64,421

 
$
63,992

 
$
429

 
$
61,617

 
$
60,679

 
$
938


No impairments of other intangible assets were recognized in either of the nine months ended September 30, 2017 or 2016.
Note 8
Goodwill
Changes in goodwill (in thousands):
 
Balance, December 31, 2016
$
12,857

Effects of foreign currency translation
185

Balance, September 30, 2017
$
13,042



Goodwill by segment (in thousands):

11



 
 
September 30,
2017
Consumer Media
$
580

Mobile Services
2,164

Games
10,298

Total goodwill
$
13,042


No impairment of goodwill was recognized in either of the nine months ended September 30, 2017 or in 2016.
Note 9
Accrued and Other Current Liabilities
Accrued and other current liabilities (in thousands):
 
 
September 30, 2017
 
December 31, 2016
Royalties and other fulfillment costs
$
2,951

 
$
2,629

Employee compensation, commissions and benefits
3,690

 
5,136

Sales, VAT and other taxes payable
2,944

 
3,258

Other
3,348

 
4,402

Total accrued and other current liabilities
$
12,933

 
$
15,425

Note 10
Restructuring Charges
Restructuring and other charges in 2017 and 2016 consist of costs associated with the ongoing reorganization of our business operations and our ongoing expense re-alignment efforts. The expense amounts in both years relate primarily to severance costs due to workforce reductions.
Restructuring charges are as follows (in thousands):
 
Employee Separation Costs
Costs incurred and charged to expense for the nine months ended September 30, 2017
$
2,271

Costs incurred and charged to expense for the nine months ended September 30, 2016
$
1,297

Changes to the accrued restructuring liability (which is included in Accrued and other current liabilities) for 2017 (in thousands) are as follows:
 
Employee Separation Costs
Accrued liability at December 31, 2016
$
209

Costs incurred and charged to expense for the nine months ended September 30, 2017
2,271

Cash payments
(2,024
)
Accrued liability at September 30, 2017
$
456


12



Note 11
Lease Exit and Related Charges
As a result of the reduction in use of RealNetworks' office space, lease exit and related charges have been recognized representing rent and contractual operating expenses over the remaining life of the leases, including estimates of sublease income expected to be received. We continue to regularly evaluate the market for office space. If the market for such space changes further in future periods, we may have to revise our estimates which may result in future adjustments to expense for excess office facilities.
Changes to accrued lease exit and related charges (which is included in Accrued and other current liabilities) for 2017 (in thousands) are as follows:
 
Accrued loss at December 31, 2016
$
3,186

Additions and adjustments to the lease loss accrual, including estimated sublease income

Less amounts paid, net of sublease amounts
(1,275
)
Accrued loss at September 30, 2017
1,911

Less current portion (included in Accrued and other current liabilities)
(313
)
Accrued loss, non-current portion (included in Other long term liabilities)
$
1,598


Note 12
Shareholders’ Equity
Accumulated Other Comprehensive Income (Loss)

Changes in components of accumulated other comprehensive income (loss) (in thousands):
 
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2017
 
2016
 
2017
 
2016
Investments
 
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss), beginning of period
 
$
4

 
$
1,464

 
$
(6
)
 
$
1,297

 
Unrealized gains (losses), net of tax effects of $0, $42, $5 and $141
 

 
72

 
10

 
239

 
Net current period other comprehensive income (loss)
 


72

 
10

 
239

 
Accumulated other comprehensive income (loss) balance, end of period
 
$
4


$
1,536

 
$
4

 
$
1,536

Foreign currency translation
 
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss), beginning of period
 
$
(60,399
)
 
$
(60,722
)
 
$
(61,639
)
 
$
(60,777
)
 
Translation adjustments
 
562

 
156

 
1,802

 
211

 
Reclassification adjustments for losses (gains) included in other income (expense)
 

 
272

 

 
272

 
Net current period other comprehensive income (loss)
 
562


428

 
1,802

 
483

 
Accumulated other comprehensive income (loss) balance, end of period
 
$
(59,837
)

$
(60,294
)
 
$
(59,837
)
 
$
(60,294
)
Total accumulated other comprehensive income (loss), end of period
 
$
(59,833
)

$
(58,758
)
 
$
(59,833
)
 
$
(58,758
)

Note 13
Income Taxes
As of September 30, 2017, there have been no material changes to RealNetworks’ uncertain tax positions disclosures as provided in Note 14 of the 2016 10-K. We do not anticipate that the total amount of unrecognized tax benefits will significantly change within the next twelve months.
We file numerous consolidated and separate income tax returns in the U.S. including federal, state and local, as well as foreign jurisdictions. With few exceptions, we are no longer subject to U.S. federal income tax examinations for tax years before 2013 or state, local, or foreign income tax examinations for years before 1993. We are currently under audit by various states and foreign jurisdictions for certain tax years subsequent to 1993.

13



Note 14
Earnings (Loss) Per Share
Basic net income (loss) per share (EPS) is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income (loss) by the weighted average number of common and dilutive potential common shares outstanding during the period. Basic and diluted EPS (in thousands, except per share amounts):
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Net income (loss)
$
(4,334
)
 
$
(3,056
)
 
$
(17,144
)
 
$
(26,574
)
Weighted average common shares outstanding used to compute basic EPS
37,200

 
36,805

 
37,112

 
36,693

Dilutive effect of stock based awards

 

 

 

Weighted average common shares outstanding used to compute diluted EPS
37,200

 
36,805


37,112


36,693

 
 
 
 
 
 
 
 
Basic EPS
$
(0.12
)
 
$
(0.08
)
 
$
(0.46
)
 
$
(0.72
)
Diluted EPS
$
(0.12
)
 
$
(0.08
)
 
$
(0.46
)
 
$
(0.72
)
During the quarter and nine months ended September 30, 2017, 5.3 million and 5.2 million shares of common stock, respectively, of potentially issuable shares from stock awards were excluded from the calculation of diluted EPS because of their antidilutive effect.
During the quarter and nine months ended September 30, 2016, 4.6 million and 4.8 million shares of common stock, respectively, of potentially issuable shares from stock awards were excluded from the calculation of diluted EPS because of their antidilutive effect.
Note 15
Commitments and Contingencies
From time to time we are and may be subject to legal proceedings, governmental investigations and claims in the ordinary course of business, including employment claims, contract-related claims, and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. Although we believe that resolving such claims, individually or in aggregate, will not have a material adverse impact on our business or financial condition, these matters are subject to inherent uncertainties. Such claims, even if not meritorious, could force us to expend significant financial and managerial resources. In addition, given the broad distribution of some of our consumer products, any individual claim related to those products could give rise to liabilities that may be material to us. In the event of a determination adverse to us, we may incur substantial monetary liability, and/or be required to change our business practices. Either of these could have a material adverse effect on our consolidated financial statements.  
Note 16
Guarantees
In the ordinary course of business, RealNetworks is subject to potential obligations for standard warranty and indemnification provisions that are contained within many of our customer license and service agreements. Our warranty provisions are consistent with those prevalent in our industry, and we do not have a history of incurring losses on warranties; therefore, we do not maintain accruals for warranty-related obligations. With regard to indemnification provisions, nearly all of our carrier contracts obligate us to indemnify our carrier customers for certain liabilities that may be incurred by them. We have received in the past, and may receive in the future, claims for indemnification from some of our carrier customers.
In relation to certain patents and other technology assets we sold to Intel in the second quarter of 2012, we have specific obligations to indemnify Intel for breaches of the representations and warranties that we made and covenants that we agreed to in the asset purchase agreement for certain potential future intellectual property infringement claims brought by third parties against Intel. The amount of any potential liabilities related to our indemnification obligations to Intel will not be determined until a claim has been made, but we are obligated to indemnify Intel up to the amount of the gross purchase price that we received in the sale.  

14



Note 17
Segment Information
We manage our business and report revenue and operating income (loss) in three segments: (1) Consumer Media, which includes our PC-based RealPlayer products, including RealPlayer Plus and related products and intellectual property licensing; (2) Mobile Services, which includes our SaaS services of our low-margin music on demand product, ringback tones, intercarrier messaging services, and our RealTimes® product; and (3) Games, which includes all our games-related businesses, including sales of mobile games, sales of games licenses, online games subscription services, advertising on games sites and social network sites, and microtransactions from online games.
We allocate certain corporate expenses which are directly attributable to supporting our businesses, including but not limited to a portion of finance, legal, human resources and headquarters facilities, to our reportable segments. Remaining expenses, which are not directly attributable to supporting the business, are reported as corporate items. Also reported in our corporate segment are restructuring charges, lease exit and related charges, as well as stock compensation charges.
RealNetworks reports three reportable segments based on factors such as how we manage our operations and how our Chief Operating Decision Maker (CODM) reviews results. The CODM reviews financial information presented on both a consolidated basis and on a business segment basis. The accounting policies used to derive segment results are the same as those described in Note 1, Description of Business and Summary of Significant Accounting Policies, in the 10-K.
Segment results for the quarters and nine months ended September 30, 2017 and 2016 (in thousands):
Consumer Media
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Revenue
$
4,197

 
$
6,482

 
$
16,817

 
$
18,608

Cost of revenue
981

 
1,507

 
3,545

 
5,485

Gross profit
3,216

 
4,975

 
13,272

 
13,123

Operating expenses
3,217

 
4,271

 
10,957

 
13,940

Operating income (loss)
$
(1
)
 
$
704

 
$
2,315

 
$
(817
)

Mobile Services
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Revenue
$
19,123

 
$
17,683

 
$
57,434

 
$
51,445

Cost of revenue
13,325

 
13,026

 
40,668

 
36,347

Gross profit
5,798

 
4,657

 
16,766

 
15,098

Operating expenses
6,437

 
8,075

 
21,261

 
26,653

Operating income (loss)
$
(639
)
 
$
(3,418
)
 
$
(4,495
)
 
$
(11,555
)


Games

 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Revenue
$
6,682

 
$
6,886

 
$
19,439

 
$
18,962

Cost of revenue
2,226

 
2,203

 
6,842

 
5,865

Gross profit
4,456

 
4,683

 
12,597

 
13,097

Operating expenses
5,071

 
4,649

 
15,108

 
14,669

Operating income (loss)
$
(615
)
 
$
34

 
$
(2,511
)
 
$
(1,572
)


15




Corporate
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Cost of revenue
$
2

 
$
4

 
$
62

 
$
(87
)
Operating expenses
2,948

 
5,705

 
10,202

 
16,948

Operating income (loss)
$
(2,950
)
 
$
(5,709
)
 
$
(10,264
)
 
$
(16,861
)

Our customers consist primarily of consumers and corporations located in the U.S., Europe, Republic of Korea and various foreign countries (Rest of the World). Revenue by geographic region (in thousands):
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
United States
$
10,084

 
$
10,642

 
$
30,713

 
$
31,379

Europe
3,337

 
3,288

 
9,736

 
10,002

Republic of Korea
12,054

 
10,582

 
37,026

 
30,227

Rest of the World
4,527

 
6,539

 
16,214

 
17,407

Total net revenue
$
30,002

 
$
31,051

 
$
93,689

 
$
89,015

Long-lived assets (which consist of equipment, software, leasehold improvements, other intangible assets, and goodwill) by geographic region (in thousands) are as follows:
 
 
September 30,
2017
 
December 31,
2016
United States
$
12,274

 
$
13,052

Europe
3,555

 
3,920

Republic of Korea
105

 
168

Rest of the World
1,596

 
1,909

Total long-lived assets
$
17,530

 
$
19,049


Note 18
Related Party Transactions
 See Note 4, Rhapsody Joint Venture, and Note 5, Fair Value Measurements, for details on transactions involving Rhapsody.



    

16



Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q and the documents incorporated herein by reference contain forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, and projections about RealNetworks’ industry, products, management’s beliefs, and certain assumptions made by management. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” and similar expressions are intended to identify forward-looking statements. All statements contained in this report that do not relate to matters of historical fact should be considered forward-looking statements. Forward-looking statements include statements with respect to:

the expected benefits and other consequences of our growth plans, strategic initiatives, and restructurings;
our expected introduction, distribution and monetization, of new and enhanced products, services and technologies across our businesses;
future revenues, gross profits, operating expenses, income and other taxes, tax benefits, net income (loss) per diluted share available to common shareholders, acquisition costs and related amortization, and other measures of results of operations;
the effects of our past acquisitions and expectations for future acquisitions and divestitures;
plans, strategies and expected opportunities for future growth, increased profitability and innovation;
the expected financial position, performance, growth and profitability of, and investment in, our businesses and the availability of resources;
the effects of legislation, regulations, administrative proceedings, court rulings, settlement negotiations and other factors that may impact our businesses;
the continuation and expected nature of certain customer relationships;
impacts of competition and certain customer relationships on the future financial performance and growth of our businesses;
our involvement in potential claims, legal proceedings and government investigations, and the potential outcomes and effects of such potential claims, legal proceedings and governmental investigations on our business, prospects, financial condition or results of operations;
the effects of U.S. and foreign income and other taxes on our business, prospects, financial condition or results of operations; and
the effect of economic and market conditions on our business, prospects, financial condition or results of operations.
These statements are not guarantees of future performance and actual actions or results may differ materially. These statements are subject to certain risks, uncertainties and assumptions that are difficult to predict, including those noted in the documents incorporated herein by reference. Particular attention should also be paid to the cautionary language in Item 1A of Part I in our 2016 10-K entitled “Risk Factors.” RealNetworks undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise, unless required by law. Readers should, however, carefully review the risk factors included in other reports or documents filed by RealNetworks from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.
Overview
RealNetworks creates innovative applications and services that make it easy to connect with and enjoy digital media. We manage our business and report revenue and operating income (loss) in three segments: (1) Consumer Media, (2) Mobile Services, and (3) Games. See Note 17 Segment Information, to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this Form 10-Q.
Within our Consumer Media segment, revenue is derived from the sales of our PC-based RealPlayer® products, including RealPlayer Plus and related products, and from the licensing of our intellectual property, primarily our codec technology, including our recently introduced RealMedia High Definition, or RMHD, technology. These products and services are delivered directly to consumers and through partners, such as OEMs and mobile device manufacturers.
Our Mobile Services business generates revenue primarily from the sale of SaaS services, which include ringback tones, RealTimes®, intercarrier messaging, and our low-margin music on demand service. We generate a significant portion of our revenue from sales within our Mobile Services business to a few mobile telecommunications carriers and our low-margin music on demand customer in Korea. The loss of these contracts or the termination or non-renewal or renegotiation of contract terms that are less favorable to us could result in the loss of future revenues and could result in the loss of anticipated profits. Our contract with our music on demand customer in Korea, LOEN, is set to expire at the end of fiscal year 2017, and we do not

17



anticipate renewal. As discussed in Note 6 Allowance for Doubtful Accounts Receivable and Sales Returns, our low-margin music on demand business generated revenue of $11.4 million and $33.8 million for the three and nine months ended September 30, 2017, respectively. While non-renewal would result in a material decline in our consolidated revenue in periods after 2017, we would not expect the impact to consolidated Gross profit to be significant as the profitability of this contract has declined over time, currently generating less than three percent of our consolidated Gross profit; or $0.3 million and $0.9 million for the three and nine months ended September 30, 2017, respectively.
Our Games business, through the GameHouse and Zylom brands, derives revenue from sales of mobile games, games licenses, online games subscription services, and advertising on games sites.
We allocate certain corporate expenses which are directly attributable to supporting our businesses, including but not limited to a portion of finance, legal, human resources and headquarters facilities, to our reportable segments. Remaining expenses, which are not directly attributable to supporting the business, are reported as corporate items. These corporate items include restructuring charges, lease exit and related charges, as well as stock compensation expense.

As of September 30, 2017, we had $59.1 million in unrestricted cash, cash equivalents and short-term investments, compared to $77.1 million as of December 31, 2016. The 2017 decrease of cash, cash equivalents, and short-term investments was due to cash used in operating activities during the first nine months of $17.5 million.

Condensed consolidated results of operations were as follows (dollars in thousands):
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Total revenue
$
30,002

 
$
31,051

 
$
(1,049
)
 
(3
)%
 
$
93,689

 
$
89,015

 
$
4,674

 
5
 %
Cost of revenue
16,534

 
16,740

 
(206
)
 
(1
)%
 
51,117

 
47,610

 
3,507

 
7
 %
Gross profit
13,468

 
14,311

 
(843
)
 
(6
)%
 
42,572

 
41,405

 
1,167

 
3
 %
Gross margin
45
%
 
46
%
 
 
 
 
 
45
%
 
47
%
 
 
 
 
Operating expenses
17,673

 
22,700

 
(5,027
)
 
(22
)%
 
57,528

 
72,210

 
(14,682
)
 
(20
)%
Operating income (loss)
$
(4,205
)
 
$
(8,389
)
 
$
4,184

 
50
 %
 
$
(14,956
)
 
$
(30,805
)
 
$
15,849

 
51
 %
In the third quarter of 2017, our total consolidated revenue decreased $1.0 million as compared with the year-earlier period. Of this decrease, $2.3 million is attributed to our Consumer Media segment, due primarily to timing of shipments by our intellectual property customers. The decrease was offset in part by a $1.4 million increase in our Mobile Services segment due primarily to increased low-margin music on demand revenue in Korea.
Cost of revenues decreased by $0.2 million for the quarter ended September 30, 2017, due in part to savings of $0.5 million in our Consumer Media segment. These savings were offset in part by higher costs of $0.3 million in our Mobile Services segment.
Operating expenses decreased by $5.0 million in the quarter ended September 30, 2017 compared with the prior year primarily due to savings realized from reductions in salaries, benefits and professional service fees, and marketing expenses totaling $2.1 million, as described more fully below, lower facilities and support services costs of $1.6 million, as well as a decrease of $1.2 million relating to decreased lease exit and related charges as compared to the prior-year period.
For the nine months ended September 30, 2017, our total consolidated revenue increased by $4.7 million, compared with the year-earlier period. Revenues increased in our Mobile Services segment by $6.0 million due primarily to increased low-margin music on demand revenue in Korea and revenue increased $0.5 million in our Games segment. These increases were offset in part by a decrease of $1.8 million in our Consumer Media segment.
Cost of revenues increased by $3.5 million in the nine months ended September 30, 2017 compared with the prior year period, resulting in a two percentage point decrease in gross margin, due to higher costs of $4.3 million in our Mobile Services segment, as well as a $1.0 million increase in our Games segment. These increases were offset by savings of $1.9 million in our Consumer Media segment.
Operating expenses decreased $14.7 million in the nine months ended September 30, 2017 as compared with the prior year due to savings realized from reductions in salaries, benefits and professional service fees, and marketing expenses totaling $12.2 million, as described more fully below. Further contributing to decreased expense as compared to the prior-year period was the impact of reduced lease exit costs of $2.2 million, as well as the benefit recorded following the receipt of warrants in the first quarter

18



of 2017 from Rhapsody of $0.5 million and the release of previously accrued taxes of $0.4 million in the first quarter of 2017. These decreases were offset by an increase of $1.0 million relating to increased restructuring costs due to increased severance charges as compared to the prior-year period.

Segment Operating Results
Consumer Media
Consumer Media segment results of operations were as follows (dollars in thousands):
 
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Revenue
 
$
4,197

 
$
6,482

 
$
(2,285
)
 
(35
)%
 
$
16,817

 
$
18,608

 
$
(1,791
)
 
(10
)%
Cost of revenue
 
981

 
1,507

 
(526
)
 
(35
)%
 
3,545

 
5,485

 
(1,940
)
 
(35
)%
Gross profit
 
3,216

 
4,975

 
(1,759
)
 
(35
)%
 
13,272

 
13,123

 
149

 
1
 %
Gross margin
 
77
%
 
77
%
 
 
 
 
 
79
%
 
71
%
 
 
 
 
Operating expenses
 
3,217

 
4,271

 
(1,054
)
 
(25
)%
 
10,957

 
13,940

 
(2,983
)
 
(21
)%
Operating income (loss)
 
$
(1
)
 
$
704

 
$
(705
)
 
(100
)%
 
$
2,315

 
$
(817
)
 
$
3,132

 
383
 %

Total Consumer Media revenue for the quarter ended September 30, 2017 decreased $2.3 million as compared to the same quarter in 2016. Intellectual property licensing revenue decreased by $1.7 million for the quarter due primarily to timing of shipment by our customers. Continuing declines in our subscription products of $0.5 million further contributed to the overall decrease as compared to the prior year period.
Cost of revenue decreased by $0.5 million during the quarter ended September 30, 2017, compared with the year-earlier period. The decrease in cost of revenue was primarily due to lower bandwidth costs of $0.2 million directly resulting from our ongoing efforts to optimize functionality and increase efficiencies.
Operating expenses decreased by $1.1 million in the quarter ended September 30, 2017, compared with the year-earlier period, primarily due to lower expenses for facilities and support services of $0.5 million as a result of our ongoing cost reduction efforts, as well as a decrease in salaries, benefits and professional services fees of $0.6 million.
Total Consumer Media revenue for the nine months ended September 30, 2017 decreased $1.8 million as compared to the same period in 2016, primarily due to continuing declines in our subscription products of $1.2 million and a decrease of $0.2 million in related advertising revenue.
Cost of revenue decreased by $1.9 million during the nine months ended September 30, 2017, compared with the year-earlier period resulting in an increase in gross margin of 8 percentage points. The decrease in cost of revenue was primarily due to lower bandwidth and other support costs of $1.5 million directly resulting from our ongoing efforts to optimize functionality and increase efficiencies.
Operating expenses decreased by $3.0 million in the nine months ended September 30, 2017, compared with the year-earlier period, due to lower expenses for facilities and support services of $1.8 million as a result of our ongoing cost reduction efforts, the acceleration of depreciation expense of $0.7 million taken in the first quarter of 2016 related to the obsolescence of e-commerce assets, and lower marketing expense of $0.3 million in 2017 compared to 2016.

19



Mobile Services
Mobile Services segment results of operations were as follows (dollars in thousands): 
 
Quarter Ended September 30,
 
Nine months ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Revenue
 
$
19,123

 
$
17,683

 
$
1,440

 
8
 %
 
$
57,434

 
$
51,445

 
$
5,989

 
12
 %
Cost of revenue
 
13,325

 
13,026

 
299

 
2
 %
 
40,668

 
36,347

 
4,321

 
12
 %
Gross profit
 
5,798

 
4,657

 
1,141

 
25
 %
 
16,766

 
15,098

 
1,668

 
11
 %
Gross margin
 
30
%
 
26
%
 
 
 
 
 
29
%
 
29
%
 
 
 
 
Operating expenses
 
6,437

 
8,075

 
(1,638
)
 
(20
)%
 
21,261

 
26,653

 
(5,392
)
 
(20
)%
Operating income (loss)
 
$
(639
)
 
$
(3,418
)
 
$
2,779

 
81
 %
 
$
(4,495
)
 
$
(11,555
)
 
$
7,060

 
61
 %
Total Mobile Services revenue increased by $1.4 million in the quarter ended September 30, 2017 compared with the prior-year period which was due to an increase of $1.5 million in our low-margin music on demand contract in Korea.
Cost of revenue increased by $0.3 million in the quarter ended September 30, 2017 compared with the prior-year period, due primarily to an increase of $1.7 million in our low-margin music on demand business related to higher sales, offset in part by reductions in salaries and benefits of $0.5 million, facilities and support services costs of $0.3 million and third-party customer service of $0.3 million.
Operating expenses decreased by $1.6 million for the quarter ended September 30, 2017 compared with the year-earlier period primarily due to reductions in salaries, benefits and professional services fees of $0.9 million and a reduction in our facilities and support services costs of $0.5 million as a result of our ongoing cost reduction efforts.
Total Mobile Services revenue increased by $6.0 million in the nine months ended September 30, 2017 compared with the prior-year period. This increase was driven by an increase of $5.9 million in our low-margin music on demand contract in Korea and an increase of $0.6 million in our ringback tones business. These increases were offset by a decrease of $0.5 million in our intercarrier messaging service.
Cost of revenue increased by $4.3 million in the nine months ended September 30, 2017 compared with the prior-year period, due to an increase of $6.3 million in our low-margin music on demand business related to higher sales. The increased cost was offset by reduced spending on third-party customer service of $0.8 million, reduced facilities spend of $0.7 million and lower bandwidth costs of $0.6 million.
Operating expenses decreased by $5.4 million for the nine months ended September 30, 2017 compared with the year-earlier period primarily due to reductions in salaries, benefits and professional services fees of $3.4 million, as well as reduced facilities and support services costs of $1.3 million as a result of our ongoing cost reduction efforts and reduced marketing spend of $0.4 million.
Games
Games segment results of operations were as follows (dollars in thousands):
 
 
Quarter Ended September 30,
 
Nine months ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Revenue
 
$
6,682

 
$
6,886

 
$
(204
)
 
(3
)%
 
$
19,439

 
$
18,962

 
$
477

 
3
 %
Cost of revenue
 
2,226

 
2,203

 
23

 
1
 %
 
6,842

 
5,865

 
977

 
17
 %
Gross profit
 
4,456

 
4,683

 
(227
)
 
(5
)%
 
12,597

 
13,097

 
(500
)
 
(4
)%
Gross margin
 
67
%
 
68
%
 
 
 
 
 
65
%
 
69
%
 
 
 
 
Operating expenses
 
5,071

 
4,649

 
422

 
9
 %
 
15,108

 
14,669

 
439

 
3
 %
Operating income (loss)
 
$
(615
)
 
$
34

 
$
(649
)
 
NM

 
$
(2,511
)
 
$
(1,572
)
 
$
(939
)
 
(60
)%
Total Games revenue declined slightly for the quarter ended September 30, 2017, compared with the year-earlier period due to a $0.5 million decrease in our other games revenue offset by a $0.3 million increase in our mobile games revenue.
Cost of revenue was flat for the quarter ended September 30, 2017 when compared with the prior-year period due to increases in app store fees related to our mobile revenue growth, offset by decreased bandwidth and advertising costs.

20



Operating expenses increased by $0.4 million in the quarter ended September 30, 2017, compared with the prior-year period primarily as a result of increased salaries and benefits costs due to our continued investment in growing our mobile games offerings.
Total Games revenue increased by $0.5 million in the nine months ended September 30, 2017, compared with the year-earlier period as a $2.0 million increase in our mobile games revenue was offset by a decrease of $1.5 million in our other games revenue.
Cost of revenue increased by $1.0 million in the nine months ended September 30, 2017 compared with the prior-year period due to increases in app store fees related to our mobile revenue growth, as well as increased royalty fees paid to developers.
Operating expenses increased by $0.4 million in the nine months ended September 30, 2017, compared with the prior-year period, due to increased salaries and benefit costs due to our continued investment in growing our mobile games offerings, offset in part by lower marketing costs.
Corporate

Corporate segment results of operations were as follows (dollars in thousands):
 
 
 
Quarter Ended September 30,
Nine months ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Cost of revenue
 
2

 
$
4

 
$
(2
)
 
50
 %
 
$
62

 
$
(87
)
 
$
149

 
171
 %
Operating expenses
 
2,948

 
5,705

 
(2,757
)
 
(48
)%
 
10,202

 
16,948

 
(6,746
)
 
(40
)%
Operating income (loss)
 
$
(2,950
)
 
$
(5,709
)
 
$
2,759

 
48
 %
 
$
(10,264
)
 
$
(16,861
)
 
$
6,597

 
39
 %
Operating expenses decreased by $2.8 million in the quarter ended September 30, 2017 compared with the year-earlier period. The decrease was primarily due to a reduction of $1.2 million in our restructuring costs due to lower lease exit and related charges compared to the prior-year period, a $0.9 million reduction in salary, benefit and professional service expenses, and a $0.7 million reduction in facilities and support services.
Operating expenses decreased by $6.7 million in the nine months ended September 30, 2017 compared with the year-earlier period. The decrease was primarily due to a $4.5 million reduction in salary, benefit and professional service expenses, a reduction of $2.2 million due to lower lease exit and related charges, and a benefit of $0.5 million relating to the warrant received from Rhapsody in the first quarter of 2017, which is discussed further in Note 5 Fair Value Measurements. These decreases were offset by an increase of $1.0 million relating to increased restructuring costs due to increased severance charges as compared to the prior-year period.
Consolidated Operating Expenses
Our operating expenses consist primarily of salaries and related personnel costs including stock based compensation, consulting fees associated with product development, sales commissions, amortization of certain intangible assets capitalized in our acquisitions, professional service fees, advertising costs, restructuring charges and lease exit costs. Operating expenses were as follows (dollars in thousands):
 
 
Quarter Ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Research and development
$
7,152

 
$
6,699

 
$
453

 
7
 %
 
$
22,085

 
$
23,185

 
$
(1,100
)
 
(5
)%
Sales and marketing
4,883

 
7,183

 
(2,300
)
 
(32
)%
 
17,534

 
24,157

 
(6,623
)
 
(27
)%
General and administrative
5,081

 
7,086

 
(2,005
)
 
(28
)%
 
15,638

 
21,380

 
(5,742
)
 
(27
)%
Restructuring and other charges
557

 
499

 
58

 
12
 %
 
2,271

 
1,297

 
974

 
75
 %
Lease exit and related charges

 
1,233

 
(1,233
)
 
(100
)%
 

 
2,191

 
(2,191
)
 
(100
)%
Total consolidated operating expenses
$
17,673

 
$
22,700

 
$
(5,027
)
 
(22
)%
 
$
57,528

 
$
72,210

 
$
(14,682
)
 
(20
)%


21



Research and development expenses increased by $0.5 million in the quarter ended September 30, 2017, compared with the year-earlier period, primarily due to an increase of $0.6 million in salaries, benefits and professional services expense, reflecting our increased efforts towards our growth initiatives.
Research and development expenses decreased by $1.1 million in the nine months ended September 30, 2017, compared with the year-earlier period. The decrease was due to the acceleration of depreciation expense of $0.7 million taken in the first quarter of 2016 and lower expenses for facilities and support services of $0.8 million as a result of our ongoing cost reduction efforts. These cost reductions were offset in part by an increase of $0.3 million in salaries, benefits and professional services expense due to increased efforts toward our growth initiatives.
Sales and marketing expenses decreased by $2.3 million in the quarter ended September 30, 2017 compared with the year-earlier period. The decrease was due to a $1.8 million reduction in salaries, benefits and professional service fees, as well as a decrease of $0.3 million from lower facilities and support services.
Sales and marketing expenses decreased by $6.6 million in the nine months ended September 30, 2017 compared with the year-earlier period. The decrease was due to a $4.4 million reduction in salaries, benefits and professional service fees, a decrease of $1.4 million in direct marketing expense and a reduction of $0.8 million from lower facilities and support services.
General and administrative expenses decreased by $2.0 million in the quarter ended September 30, 2017, compared with the year-earlier period, due to an overall decrease in salaries, benefits and professional fees of $0.8 million, and a decrease of $1.1 million related to reduced facilities and support services costs.
General and administrative expenses decreased by $5.7 million in the nine months ended September 30, 2017, compared with the year-earlier period, primarily due to an overall decrease in salaries, benefits and professional fees of $3.7 million, a decrease of $1.3 million related to reduced facilities and support services costs, as well as a first quarter of 2017 benefit of $0.5 million relating to warrants we received from Rhapsody, which are discussed further in Note 5 Fair Value Measurements. Also contributing to the decrease was a benefit of $0.4 million in the first quarter of 2017 related to the release of previously accrued taxes.
Restructuring and other charges and Lease exit and related charges consist of costs associated with the ongoing reorganization of our business operations and expense re-alignment efforts. Restructuring expense primarily relates to severance costs due to workforce reductions. For additional details on these charges see Note 10, Restructuring Charges and Note 11, Lease Exit and Related Charges.
Other Income (Expenses)
Other income (expenses), net was as follows (dollars in thousands):
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Interest income, net
$
116

 
$
119

 
$
(3
)
 
(3
)%
 
$
353

 
$
316

 
$
37

 
12
 %
Gain (loss) on investments, net

 
6,021

 
(6,021
)
 
(100
)%
 

 
5,978

 
(5,978
)
 
(100
)%
Equity in net loss of Rhapsody

 
(233
)
 
233

 
100
 %
 
(1,097
)
 
(629
)
 
(468
)
 
(74
)%
Other income (expense), net
(50
)
 
(243
)
 
193

 
(79
)%
 
(288
)
 
(515
)
 
227

 
(44
)%
Total other income (expense), net
$
66

 
$
5,664

 
$
(5,598
)
 
(99
)%
 
$
(1,032
)
 
$
5,150

 
$
(6,182
)
 
(120
)%

Gain (loss) on investments, net, decreased $6.0 million for the three and nine months ended September 30, 2017, respectively. The decrease is due to the prior year receipt and recognition of a $4.0 million payment from our 2015 sale of the Slingo and social casino business, and to the receipt of proceeds of $2.0 million, net of transaction costs, from the sale of a domain name.

We account for our investment in Rhapsody under the equity method of accounting, as described in Note 4, Rhapsody Joint Venture. The net carrying value of our investment in Rhapsody is not necessarily indicative of the underlying fair value of our investment.

22



Income Taxes
During the quarters ended September 30, 2017 and 2016, we recognized income tax expense of $0.2 million and $0.3 million, respectively, related to U.S. and foreign income taxes. The change in income tax expense during the quarter ended September 30, 2017 was largely the result of changes in our jurisdictional income.
As of September 30, 2017, there have been no material changes to RealNetworks’ uncertain tax positions disclosures as provided in Note 14 of the 2016 10-K. We do not anticipate that the total amount of unrecognized tax benefits will significantly change within the next twelve months.
The majority of our tax expense is due to income in our foreign jurisdictions and we have not benefitted from losses in the U.S. and certain foreign jurisdictions in the third quarter of 2017. We generate income in a number of foreign jurisdictions, some of which have higher or lower tax rates relative to the U.S. federal statutory rate. Our tax expense could fluctuate significantly on a quarterly basis to the extent income is less than anticipated in countries with lower statutory tax rates and more than anticipated in countries with higher statutory tax rates. For the quarter ended September 30, 2017, decreases in tax expense from income generated in foreign jurisdictions with lower tax rates in comparison to the U.S. federal statutory rate was offset by increases in tax expense from income generated in foreign jurisdictions having comparable, or higher tax rates in comparison to the U.S. federal statutory rate. The effect of differences in foreign tax rates on the Company's tax expense for the third quarter of 2017 was minimal.
As of September 30, 2017, we have not provided for U.S. federal and state income taxes on certain undistributed earnings of our foreign subsidiaries, since such earnings are considered indefinitely reinvested outside the U.S. or may be remitted tax-free to the U.S. If these amounts were distributed to the U.S., in the future in the form of dividends or otherwise, RealNetworks could be subject to additional U.S. income and foreign withholding taxes. It is not practicable to determine the foreign withholding and U.S. income tax liability or benefit on such earnings due to the timing of such future distributions, the availability of foreign tax credits, and the complexity of the computation if such earnings were not deemed to be permanently reinvested. If future events, including material changes in estimates of cash, working capital, and long-term investment requirements necessitate that these earnings be distributed, an additional provision for U.S. income and foreign withholding taxes may be necessary.
We file numerous consolidated and separate income tax returns in the U.S., including federal, state and local returns, as well as in foreign jurisdictions. With few exceptions, we are no longer subject to United States federal income tax examinations for tax years prior to 2013 or state, local or foreign income tax examinations for years prior to 1993. We are currently under audit by various states and foreign jurisdictions for certain tax years subsequent to 1993.
Geographic Revenue
Revenue by geographic region was as follows (dollars in thousands):
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
United States
$
10,084

 
$
10,642

 
$
(558
)
 
(5
)%
 
$
30,713

 
$
31,379

 
$
(666
)
 
(2
)%
Europe
3,337

 
3,288

 
49

 
1
 %
 
9,736

 
10,002

 
(266
)
 
(3
)%
Republic of Korea
12,054

 
10,582

 
1,472

 
14
 %
 
37,026

 
30,227

 
6,799

 
22
 %
Rest of world
4,527

 
6,539

 
(2,012
)
 
(31
)%
 
16,214

 
17,407

 
(1,193
)
 
(7
)%
Total net revenue
$
30,002

 
$
31,051

 
$
(1,049
)
 
(3
)%
 
$
93,689

 
$
89,015

 
$
4,674

 
5
 %
Revenue in the United States decreased by $0.6 million in the quarter ended September 30, 2017 compared with the year-earlier period, primarily due to decreases in our Mobile Services segment.
Revenue in the United States decreased by $0.7 million in the nine months ended September 30, 2017 as compared to the prior-year period, primarily due to lower revenue in our Mobile Services and Consumer Media segments, offset by increases in our Games segment .
Revenue in Europe was flat in the quarter ended September 30, 2017 compared with the year-earlier period due to lower revenues generated by our Games segments, offset by slight increases in our Mobile Services segment.

23



Revenue in Europe decreased by $0.3 million in the nine months ended September 30, 2017 compared with the year-earlier period due to lower revenues generated by our Games segment, offset in part by a slight increases in our Consumer Media and Mobile Services segments.
Revenue in Korea increased by $1.5 million in the quarter ended September 30, 2017 compared with the year-earlier period. The increase is due to additional revenues of $1.5 million generated by our low-margin music on demand services in our Mobile Services segment, which is the primary source of revenue in Korea.
Revenue in Korea increased by $6.8 million in the nine months ended September 30, 2017 compared with the year-earlier period. Of this increase, $5.9 million was generated by our low-margin music on demand services in our Mobile Services segment and an additional $1.2 million due to increased sales of intellectual property in our Consumer Media segment.
Revenue in the rest of world decreased by $2.0 million in the quarter ended September 30, 2017 compared with the year-earlier period. The decrease was due to lower revenues in our Consumer Media segment due to timing of shipment by our customers.
Revenue in the rest of world decreased by $1.2 million in the nine months ended September 30, 2017 compared with the year-earlier period. The decrease was due to lower revenues of $2.6 million in our Consumer Media segment, offset in part by increased revenues in our Mobile Services segment of $1.7 million.
New Accounting Pronouncements

See Note 2, Recent Accounting Pronouncements, to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this 10-Q.

Liquidity and Capital Resources
The following summarizes working capital, cash, cash equivalents, short-term investments, and restricted cash (in thousands):
 
 
September 30, 2017
 
December 31, 2016
Working capital
$
56,295

 
$
66,304

Cash, cash equivalents, and short-term investments
59,079

 
77,052

Restricted cash equivalents and investments
2,400

 
2,700


The 2017 decrease of cash, cash equivalents, and short-term investments from December 31, 2016 was due primarily to our ongoing negative cash flows used in operating activities, which totaled $17.5 million in the first nine months of 2017.
The following summarizes cash flow activity (in thousands):
 
 
Nine months ended September 30,
 
2017
 
2016
Cash provided by (used in) operating activities
$
(17,543
)
 
$
(22,294
)
Cash provided by (used in) investing activities
28,108

 
13,490

Cash provided by (used in) financing activities
(208
)
 
(677
)
Cash used in operating activities consisted of net income (loss) adjusted for certain non-cash items such as depreciation and amortization, and the effect of changes in certain operating assets and liabilities.
Cash used in operating activities was $4.8 million less in the nine months ended September 30, 2017 as compared to the same period in 2016. Cash used in operations was less due primarily to a lower operating loss for 2017 than the same period in the prior year, driven mainly by our ongoing cost reduction efforts, as previously discussed. The effect of the lower operating loss was offset in part by the change in operating assets and liabilities during 2017 compared to 2016. In the current year, we used cash of $6.5 million from the net change in operating assets and liabilities while in 2016 the net change in operating assets and liabilities used $1.0 million.

24



For the nine months ended September 30, 2017, cash provided by investing activities of $28.1 million was due to sales and maturities, net of purchases, of short-term investments, which totaled $29.8 million. The increase was offset in part by our advance paid to Rhapsody of $1.5 million, as discussed further in Note 4 Rhapsody Joint Venture, and fixed asset purchases of $0.5 million.
For the nine months ended September 30, 2016, cash provided by investing activities of $13.5 million was due to sales and maturities, net of purchases, of short-term investments, which totaled $9.3 million, the receipt of proceeds of $4.0 million from the first anniversary payment relating to the 2015 sale of the Slingo and social casino games business, and the receipt of $2.1 million relating to the sale of a domain name, both of which occurred in the third quarter of 2016. These increases were partially offset by purchases of equipment, software and leasehold improvements of $2.0 million.
Cash used in financing activities for the nine months ended September 30, 2017 was $0.2 million. This cash outflow was due mainly to tax payments on shares withheld upon vesting of restricted stock.
Cash used in financing activities for the nine months ended September 30, 2016 was $0.7 million. This cash outflow was primarily due to tax payments on shares withheld upon vesting of restricted stock.
While we currently have no planned significant capital expenditures for the remainder of 2017 other than those in the ordinary course of business, we do have contractual commitments for future payments related to office leases.
We believe that our current unrestricted cash, cash equivalents, and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.
In the future, we may seek to raise additional funds through public or private equity financing, or through other sources such as credit facilities. Such sources of funding may or may not be available to us at commercially reasonable terms. The sale of additional equity securities could result in dilution to our shareholders. In addition, in the future, we may enter into cash or stock acquisition transactions or other strategic transactions that could reduce cash available to fund our operations or result in dilution to shareholders.
If Rhapsody continues to incur losses, if it otherwise experiences a significant decline in its business or financial condition, or if we provide financial support to or increase our investment in Rhapsody, we could incur further losses on our investment, which could have an adverse effect on our financial condition, liquidity, and results of operations. For further information on Rhapsody, please refer to Note 4 Rhapsody Joint Venture.
Our cash equivalents and short-term investments consist of investment grade securities, as specified in our investment policy guidelines. The policy limits the amount of credit exposure to any one non-U.S. Government or non-U.S. Agency issue or issuer to a maximum of 5% of the total portfolio. These securities are subject to interest rate risk and will decrease in value if interest rates increase. Because we have historically had the ability to hold our fixed income investments until maturity, we do not expect our operating results or cash flows to be significantly affected by a sudden change in market interest rates in our securities portfolio.
We conduct our operations primarily in five functional currencies: the U.S. dollar, the Korean won, the Japanese yen, the British pound and the euro. We currently do not actively hedge our foreign currency exposures and are therefore subject to the risk of exchange rate fluctuations. We are exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. Our exposure to foreign exchange rate fluctuations also arises from intercompany payables and receivables to and from our foreign subsidiaries.
As of September 30, 2017, approximately $19.6 million of unrestricted cash, cash equivalents, and short-term investments was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we may be required to accrue and pay U.S. income and foreign withholding taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Additionally, the Company currently has significant net operating losses and other tax attributes that could be used to offset potential U.S. income tax that could result if these amounts were distributed to the U.S. We utilize a variety of tax planning and financing strategies in an effort to ensure that our worldwide cash is available in the locations in which it is needed. We do not expect restrictions or potential taxes on repatriation of amounts held outside of the U.S to have a material effect on our overall liquidity, financial condition or results of operations.


25



Off-Balance Sheet Arrangements
We have operating lease obligations for office facility leases with future cash commitments that are not required to be recorded on our consolidated balance sheet. Accordingly, these operating lease obligations constitute off-balance sheet arrangements. In addition, since we do not maintain accruals associated with certain guarantees, as discussed in Note 16, Guarantees, to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this 10-Q, those guarantee obligations also constitute off-balance sheet arrangements.

Critical Accounting Policies and Estimates
The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Our critical accounting policies and estimates are as follows:
Revenue recognition;
Estimating music publishing rights and music royalty accruals;
Estimating recoverability of deferred costs;
Estimating allowances for doubtful accounts and sales returns;
Estimating losses on excess office facilities;
Valuation of equity method investments;
Valuation of definite-lived assets;
Valuation of goodwill;
Stock-based compensation; and
Accounting for income taxes.
Revenue Recognition. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Physical products are considered delivered to the customer once they have been shipped and title and risk of loss have been transferred. For online sales, the products or services are considered delivered at the time the product or services are made available, digitally, to the end user.
We recognize revenue on a gross or net basis. In most arrangements, we contract directly with end user customers, and are the primary obligor. In such arrangements, we recognize revenue on a gross basis. In some cases, we utilize third-party distributors who are the primary obligor to sell products or services directly to end user customers. In such instances, we recognize revenue on a net basis.
In our direct to consumer operations, we derive revenue primarily through (1) subscriptions sold by our Games segment and subscriptions of SuperPass within our Consumer Media segment, (2) sales of content downloads, software and licenses offered by our Consumer Media, Mobile Services, and Games segments and (3) the sale of advertising and the distribution of third-party products on our websites and in our games.
Consumer subscription products are paid in advance, typically for monthly, quarterly or annual duration. Subscription revenue is recognized ratably over the related subscription time period. Revenue from sales of content downloads, software and licenses is recognized at the time the product is made available, digitally, to the end user. Revenue generated from advertising on our websites and from advertising and the distribution of third-party products included in our products is recognized as revenue at the time of delivery.
We also generate revenue through business-to-business channels by providing services within our Mobile Services segment enabling mobile carriers to deliver audio and video content to their customers and by selling software licenses and products and related support and other services. Revenue generated from services provided to mobile carriers that enable the delivery of audio and video content to their customers is recognized as the services are provided. Setup fees to build these services are recognized ratably upon launch of the service over the remaining expected term of the service.
Non-software revenue arrangements containing multiple elements are divided into separate units of accounting, after being evaluated for specific criteria. If the criteria for separation are met, revenue is allocated to the individual units using the relative price method. If the criteria are not met, the elements are treated as one unit of accounting and revenue recognition is delayed until all elements have been delivered. In the case of revenue arrangements containing software, elements are divided into separate units of accounting only when vendor-specific objective evidence has been established. In cases where vendor-specific objective evidence has not been established, undelivered elements are combined into one unit of accounting and are not recognized in revenue until all elements have been delivered.
Estimating Music Publishing Rights and Music Royalty Accruals. We have made estimates of amounts that may be owed related to music royalties for our historical domestic and international music services. Material differences may impact the

26



amount and timing of our expense for any period if management made different judgments or utilized different estimates. Under copyright law, we may be required to pay licensing fees for digital sound recordings and compositions we have delivered. Copyright law generally does not specify the rate and terms of the licenses, which are determined by voluntary negotiations among the parties or, for certain compulsory licenses where voluntary negotiations are unsuccessful, by arbitration. Our estimates are based on contracted or statutory rates, when established, or management’s best estimates based on facts and circumstances regarding the specific music services and agreements in similar geographies or with similar agencies. While we have based our estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances, actual results may differ materially from these estimates under different assumptions or conditions.
Estimating Recoverability of Deferred Costs. We defer costs on projects for service revenue and system sales. Deferred costs consist primarily of direct and incremental costs to customize and install systems, as defined in individual customer contracts, including costs to acquire hardware and software from third parties and payroll costs for our employees and other third parties. We recognize such costs as a component of cost of revenue, the timing of which is dependent upon the revenue recognition policy by contract. For revenue recognized under the completed contract method, costs are deferred until the products are delivered, or upon completion of services or, where applicable, customer acceptance. For revenue recognized under the percentage of completion method, costs are recognized as products are delivered or services are provided in accordance with the percentage of completion calculation. For revenue recognized ratably over the term of the contract, costs are recognized ratably over the term of the contract, commencing on the date of revenue recognition. At each balance sheet date, we review deferred costs to ensure they are ultimately recoverable. Any anticipated losses on uncompleted contracts are recognized when evidence indicates the estimated total cost of a contract exceeds its estimated total revenue.
Assessing the recoverability of deferred project costs is based on significant assumptions and estimates, including future revenue and cost of sales. Significant or sustained decreases in revenue or increases in cost of sales in future periods could result in impairments of deferred project costs. We cannot accurately predict the amount and timing of any such impairments. Should the value of deferred project costs become impaired, we would record the appropriate charge, which could have a material adverse effect on our financial condition or results of operations.
Estimating Allowances for Doubtful Accounts and Sales Returns. We make estimates of the uncollectible portion of our accounts receivable. We specifically analyze the age of accounts receivable and historical bad debts, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. Similarly, we make estimates of potential future product returns related to current period revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns allowance. Significant judgments and estimates are made and used in connection with establishing allowances for doubtful accounts and sales returns. Material differences may result in the amount and timing of our revenue for any period if we were to make different judgments or utilize different estimates or actual future experience was different from the judgments and estimates.
Estimating losses on excess office facilities. We make significant estimates in determining the appropriate amount of accrued loss on excess office facilities, including estimates of sublease income expected to be received. If we make different estimates, our loss on excess office facilities could be significantly different from that recorded, which could have a material impact on our operating results.
Valuation of Equity Method Investments. We use the equity method of accounting for investments in circumstances where we have the ability to exert significant influence, but not control, over an investee or joint venture. We record our percentage interest in the investee's recorded income or loss and changes in the investee's capital under this method, which will increase or decrease the reported value of our investment. See Note 4, Rhapsody Joint Venture, to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this 10-Q, for additional information. We initially record our investment based on a fair value analysis of the investment.
We evaluate impairment of an investment valued under the equity method if events and circumstances warrant. An impairment charge would be recorded if a decline in value of an equity investment below its carrying amount were determined to be other than temporary. In determining if a decline is other than temporary, we consider factors such as the length of time and extent to which the fair value of the investment has been less than the carrying amount of the investee or joint venture, the near-term and longer-term operating and financial prospects of the investee or joint venture and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery.
Valuation of Definite-Lived Assets. Definite-lived assets consist primarily of property, plant and equipment, as well as amortizable intangible assets acquired in business combinations. Definite-lived assets are amortized on a straight line basis over their estimated useful lives. We review definite-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Recoverability of these assets is measured by comparison

27



of their carrying amount to future undiscounted cash flows the assets are expected to generate. If definite-lived assets are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds their fair market value.
The impairment analysis of definite-lived assets is based upon estimates and assumptions relating to our future revenue, cash flows, operating expenses, costs of capital and capital purchases. These estimates and assumptions are complex and subject to a significant degree of judgment with respect to certain factors including, but not limited to, the cash flows of our long-term operating plans, market and interest rate risk, and risk-commensurate discount rates and cost of capital. Significant or sustained declines in future revenue or cash flows, or adverse changes in our business climate, among other factors, and their resulting impact on the estimates and assumptions relating to the value of our definite-lived assets could result in the need to perform an impairment analysis in future periods which could result in a significant impairment. While we believe our estimates and assumptions are reasonable, due to their complexity and subjectivity, these estimates and assumptions could vary from period to period. Changes in these estimates and assumptions could materially affect the estimate of future undiscounted cash flows and related fair market values of these assets and result in significant impairments, which could have a material adverse effect on our financial condition or results of operations. For further discussion, please see the risk factor entitled, "Any impairment to our goodwill, and definite-lived assets could result in a significant charge to our earnings" under Item 1A Risk Factors of our 2016 10-K.
Valuation of Goodwill.  We test goodwill for impairment on an annual basis, in our fourth quarter, or more frequently if circumstances indicate reporting unit carrying values may exceed their fair values. Circumstances that may indicate a reporting unit's carrying value exceeds its fair value include, but are not limited to: poor economic performance relative to historical or projected future operating results; significant negative industry, economic or company specific trends; changes in the manner of our use of the assets or the plans for our business; and loss of key personnel.
When evaluating goodwill for impairment, based upon our annual test or due to changes in circumstances described above, we first perform a qualitative assessment to determine if the fair value of a reporting unit is more likely than not less than the reporting unit's carrying amount including goodwill. If this assessment indicates it is more likely than not, we then compare the carrying value of the reporting unit to the estimated fair value of the reporting unit. If the carrying value of the reporting unit exceeds the estimated fair value, we then calculate the implied estimated fair value of goodwill for the reporting unit and compare it to the carrying amount of goodwill for the reporting unit. If the carrying amount of goodwill exceeds the implied estimated fair value, an impairment charge to current operations is recorded to reduce the carrying value to implied estimated value.
Significant judgments and estimates are required in determining the reporting units and assessing the fair value of the reporting units. These estimates and assumptions are complex and subject to a significant degree of judgment with respect to certain factors including, but not limited to, the cash flows of long-term operating plans, market and interest rate risk, and risk-commensurate discount rates and cost of capital.
Stock-Based Compensation. Stock-based compensation cost is estimated at the grant date based on the award’s fair value and is recognized as expense over the requisite service period, which is the vesting period. For stock options, the fair value is calculated using the Black-Scholes option-pricing model or other appropriate valuation models such as a Monte Carlo simulation. The valuation models require various highly judgmental assumptions including volatility in our common stock price and expected option life. If any of the assumptions used in the valuation models change significantly, stock-based compensation expense for new awards may differ materially in the future from the amounts recorded in our consolidated statement of operations. For all awards, we are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting forfeitures.
Accounting for Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year. In addition, deferred income tax expense and deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities and operating loss and tax credit carryforwards are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and operating loss and tax credit carryforwards are expected to be recovered or settled. We must make assumptions, judgments and estimates to determine the current and deferred provision for income taxes, deferred tax assets and liabilities and any valuation allowance to be recorded against deferred tax assets. Our judgments, assumptions, and estimates relative to the current provision for income tax take into account current tax laws, our interpretation of current tax laws and possible outcomes of future audits conducted by foreign and domestic tax authorities. Changes in tax law or our interpretation of tax laws and future tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements.

28



Each reporting period we must periodically assess the likelihood that our deferred tax assets will be recovered from future sources of taxable income, and to the extent that recovery is not more likely than not, a valuation allowance must be established. The establishment of a valuation allowance and increases to such an allowance result in either increases to income tax expense or reduction of income tax benefit in the statement of operations and comprehensive income. In certain instances, changes in the valuation allowance may be allocated directly to the related components of shareholders' equity on the consolidated balance sheet. Factors we consider in making such an assessment include, but are not limited to, past performance and our expectation of future taxable income, macroeconomic conditions and issues facing our industry, existing contracts, our ability to project future results and any appreciation of our investments and other assets.
As of September 30, 2017, $19.6 million of the $59.1 million of cash, cash equivalents, and short-term investments was held by our foreign subsidiaries.
As of September 30, 2017, we have not provided for U.S. federal and state income taxes on certain undistributed earnings of our foreign subsidiaries, since such earnings are considered indefinitely reinvested outside the U.S. or may be remitted tax-free to the U.S. If these amounts were distributed to the U.S., in the form of dividends or otherwise, RealNetworks could be subject to additional U.S. income and foreign withholding taxes. It is not practicable to determine the foreign withholding and U.S. federal income tax liability or benefit on such earnings due to the timing of such future distributions, the availability of foreign tax credits, and the complexity of the computation if such earnings were not deemed to be permanently reinvested. If future events, including material changes in estimates of cash, working capital, and long-term investment requirements necessitate that these earnings be distributed, an additional provision for U.S. income and foreign withholding taxes may be necessary.

Item 3.
Quantitative and Qualitative Disclosures About Market Risk
The following discussion about our market risk involves forward-looking statements. All statements that do not relate to matters of historical fact should be considered forward-looking statements. Actual results could differ materially from those projected in any forward-looking statements.
Interest Rate Risk. Our exposure to interest rate risk from changes in market interest rates relates primarily to our short-term investment portfolio. Our short-term investments consist of investment grade debt securities as specified in our investment policy. Investments in both fixed and floating rate instruments carry a degree of interest rate risk. The fair value of fixed rate securities may be adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Additionally, a declining rate environment creates reinvestment risk because as securities mature the proceeds are reinvested at a lower rate, generating less interest income. See Note 5, Fair Value Measurements, to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this Form 10-Q, for additional information. Due in part to these factors, our future interest income may be adversely impacted due to changes in interest rates. In addition, we may incur losses in principal if we are forced to sell securities that have declined in market value due to changes in interest rates. Because we have historically had the ability to hold our short-term investments until maturity, we would not expect our operating results or cash flows to be significantly impacted by a sudden change in market interest rates. There have been no material changes in our investment methodology regarding our cash equivalents and short-term investments during the quarter ended September 30, 2017. Based on our cash, cash equivalents, short-term investments, and restricted cash equivalents as of September 30, 2017, a hypothetical 10% increase/decrease in interest rates would not increase/decrease our annual interest income or cash flows by more than a nominal amount.
Investment Risk. As of September 30, 2017, we had an investment in the voting capital stock of a privately held technology company. See Note 1, Description of Business and Summary of Significant Accounting Policies - Equity Method Investments, and Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates (Valuation of equity method investments) in our Form 10-K for details on our accounting treatment for this investment, including the analysis of other-than-temporary impairments.
Foreign Currency Risk. We conduct business internationally in several currencies and thus are exposed to adverse movements in foreign currency exchange rates.
Our exposure to foreign exchange rate fluctuations arise in part from: (1) translation of the financial results of foreign subsidiaries into U.S. dollars in consolidation; (2) the remeasurement of non-functional currency assets, liabilities and intercompany balances into U.S. dollars for financial reporting purposes; and (3) non-U.S. dollar denominated sales to foreign customers. We manage a portion of these risks through the use of financial derivatives, but fluctuations could impact our results of operations and financial position.
Where appropriate, we manage foreign currency risk for certain material short-term intercompany balances through the use of foreign currency forward contracts. These contracts require us to exchange currencies at rates agreed upon at the

29



contract’s inception. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the short-term intercompany balances, these financial instruments help alleviate the risk that might otherwise result from certain changes in currency exchange rates. We do not designate our foreign exchange forward contracts related to short-term intercompany accounts as hedges and, accordingly, we adjust these instruments to fair value through results of operations. However, we may periodically hedge a portion of our foreign exchange exposures associated with material firmly committed transactions, long-term investments, highly predictable anticipated exposures and net investments in foreign subsidiaries. To the extent we continue to experience adverse economic conditions, our unhedged exposures are impacted by movements in currency exchange rates and we may record losses related to such unhedged exposures in future periods that may have a material adverse effect on our financial condition and results of operations.
Our foreign currency risk management program reduces, but does not entirely eliminate, the impact of currency exchange rate movements.
We have cash balances denominated in foreign currencies which are subject to foreign currency fluctuation risk. The majority of our foreign currency denominated cash is held in Korean won and euros. A hypothetical 10% increase or decrease in the Korean won and euro relative to the U.S. dollar as of September 30, 2017 would not result in a material impact on our financial position, results of operations or cash flows.
Item 4.
Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2017. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Based upon that evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2017, our disclosure controls and procedures were effective.
(b) Changes in Internal Control over Financial Reporting
There have been no changes in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the third quarter of 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

30



PART II. OTHER INFORMATION
 
Item 1.
Legal Proceedings
See Note 15, Commitments and Contingencies, to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this Form 10-Q.
Item 1A.
Risk Factors

Our operations and financial results are subject to various risks and uncertainties. Readers should carefully consider the risk factors included in Part I, Item 1A, "Risk Factors" in our Annual Report on Form 10-K (as amended) for the year ended December 31, 2016, which could adversely affect our business or financial condition, including (without limitation) results of operations, liquidity and the trading price of our common stock. There have been no material changes to our risk factors since our Annual Report on Form 10-K for the year ended December 31, 2016. The risks described in our 2016 Form 10-K and in this and other reports filed with the Securities and Exchange Commission are not the only risks facing our company. Additional risks and uncertainties not presently known to us or that we presently deem less significant may also materially adversely affect our business or financial condition.
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
(a) Not applicable
(b) Not applicable
(c) Not applicable
Item 3.
Default Upon Senior Securities
None 
Item 4.
Mine Safety Disclosures
Not applicable
Item 5.
Other Information
None.
Item 6.
Exhibits
See Index to Exhibits below.

 



31



SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Form 10-Q Report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
REALNETWORKS, INC.
 
 
 
 
By:
 
/s/    Cary Baker
 
 
 
Cary Baker
 
Title:
 
Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)


Dated: November 2, 2017

32



INDEX TO EXHIBITS
 
Exhibit
Number
Description
 
 
31.1
 
 
31.2
 
 
32.1
 
 
32.2
 
 
101.INS
XBRL Instance Document
 
 
101.SCH
XBRL Taxonomy Extension Schema Document
 
 
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
 
 
 
 




 

33