<PAGE>
FORM 10-QSB
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED September 30, 1998
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: 000-22023
MACROVISION CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 77-0156161
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1341 Orleans Drive
Sunnyvale, California 94089
(Address of principal executive offices) (Zip code)
(408) 743-8600
(Registrant's telephone number including area code)
Check whether the issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12
months (or for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements for the
past 90 days. Yes _X_ No ___
State the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Title Outstanding as of October 30, 1998
Common Stock, $0.001 par value 8,730,626
Transitional Small Business Disclosure Format (check one):
Yes ___ No _X_
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MACROVISION CORPORATION
FORM 10-QSB
INDEX
PART I. FINANCIAL INFORMATION Page
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets
as of September 30, 1998 and December 31, 1997................. 3
Condensed Consolidated Statements of Income
for the Three Month Periods Ended September 30, 1998
and 1997, and the Nine Month Periods Ended
September 30, 1998 and 1997.................................... 4
Condensed Consolidated Statements of Cash Flows
for the Nine Month Periods Ended September 30, 1998
and 1997....................................................... 5
Notes to Condensed Consolidated Financial Statements............. 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations...................................... 9
Item 3. Risk Factors..................................................... 13
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................ 21
Item 5. Other Information................................................ 21
Item 6. Exhibits and Reports on Form 8-K................................. 21
Signatures................................................................. 22
2
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PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.
MACROVISION CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
(Unaudited)
------------- ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 4,630 $ 1,314
Short-term investments 20,269 11,241
Accounts receivable, less allowance for doubtful
accounts of $792 and $684 5,468 5,240
Inventories 402 433
Deferred tax assets 2,160 1,336
Prepaid expenses and other assets 929 709
-------- --------
Total current assets 33,858 20,273
Property and equipment, net 1,401 1,722
Patents and other intangibles, net 1,425 1,098
Long-term marketable investment securities 17,587 1,763
Other assets 9,007 4,000
-------- --------
$ 63,278 $ 28,856
-------- --------
-------- --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Account payable $ 1,068 $ 919
Accrued expenses 2,152 2,190
Deferred revenue 1,788 944
Income taxes payable 976 846
Current portion of capital lease obligation 111 108
-------- --------
Total current liabilities 6,095 5,007
Capital lease obligation, net of current portion 105 188
Deferred tax liabilities 817 84
-------- --------
7,017 5,279
Stockholders' equity:
Common stock 9 7
Additional paid-in capital 51,707 23,277
Stockholder's note receivable (78) (131)
Deferred stock compensation - (96)
Accumulated other comprehensive loss (229) (214)
Retained earnings 4,852 734
-------- --------
Total stockholders' equity 56,261 23,577
-------- --------
$ 63,278 $ 28,856
-------- --------
-------- --------
</TABLE>
See the accompanying notes to these condensed consolidated financial statements.
3
<PAGE>
MACROVISION CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- -------------------------
1998 1997 1998 1997
---------- --------- ---------- ---------
<S> <C> <C> <C> <C>
Net revenues $ 6,307 $ 5,040 $ 17,150 $ 14,326
---------- --------- ---------- ---------
Costs and expenses:
Cost of revenues 592 444 1,439 1,822
Research and development 690 549 1,967 1,622
Selling and marketing 1,354 1,472 4,367 4,398
General and administrative 1,114 1,021 3,401 2,918
---------- --------- ---------- ---------
Total costs and expenses 3,750 3,486 11,174 10,760
---------- --------- ---------- ---------
Operating income 2,557 1,554 5,976 3,566
Interest and other income, net 382 138 685 311
---------- --------- ---------- ---------
Income before income taxes 2,939 1,692 6,661 3,877
Income taxes 1,129 644 2,543 1,518
---------- --------- ---------- ---------
Net income $ 1,810 $ 1,048 $ 4,118 $ 2,359
---------- --------- ---------- ---------
---------- --------- ---------- ---------
Computation of basic and diluted earnings per share:
Net income $ 1,810 $ 1,048 $ 4,118 $ 2,359
Preferred stock dividends - - - (156)
---------- --------- ---------- ---------
Earnings applicable to common stock $ 1,810 $ 1,048 $ 4,118 $ 2,203
---------- --------- ---------- ---------
---------- --------- ---------- ---------
Basic earnings per share $ 0.21 $ 0.15 $ 0.53 $ 0.35
---------- --------- ---------- ---------
---------- --------- ---------- ---------
Shares used in computing basic earnings per share 8,692 7,145 7,750 6,243
---------- --------- ---------- ---------
---------- --------- ---------- ---------
Diluted earnings per share $ 0.20 $ 0.14 $ 0.50 $ 0.33
---------- --------- ---------- ---------
---------- --------- ---------- ---------
Shares used in computing diluted earnings per share 9,246 7,675 8,282 6,738
---------- --------- ---------- ---------
---------- --------- ---------- ---------
</TABLE>
See the accompanying notes to these condensed consolidated financial statements.
4
<PAGE>
MACROVISION CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
1998 1997
--------- ---------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 4,118 $ 2,359
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization 699 890
Deferred income taxes (91) (789)
Amortization of deferred stock compensation 96 108
Changes in operating assets and liabilities:
Accounts receivable, inventories, and other current assets (727) (1,092)
Accounts payable, accrued expenses, deferred revenue
and income taxes payable 1,085 664
Other (67) 44
--------- ---------
Net cash provided by operating activities 5,113 2,184
--------- ---------
Cash flows from investing activities:
Purchases of long-term marketable investment securities (18,364) -
Sales or maturities of long-term marketable investment securities 2,541 -
Purchases of short-term investments (47,120) (41,895)
Sales or maturities of short-term investments 38,160 29,715
Acquisition of property and equipment (210) (484)
Payments for patents and other intangibles (512) (223)
Proceeds from related party receivable 310 -
Investment in C-Dilla Limited and CAC (4,053) (792)
Prepaid future royalties to C-Dilla Limited (945) -
Other, net (9) (77)
--------- ---------
Net cash used in investing activities (30,202) (13,756)
--------- ---------
Cash flows from financing activities:
Payments on capital lease obligations (80) (78)
Proceeds from issuance of common stock, net 28,432 14,060
Payment of stockholder's note receivable 53 26
Cash dividends - (156)
--------- ---------
Net cash provided by financing activities 28,405 13,852
--------- ---------
Net increase in cash and cash equivalents 3,316 2,280
Cash and cash equivalents at beginning of period 1,314 2,409
--------- ---------
Cash and cash equivalents at end of period $ 4,630 $ 4,689
--------- ---------
--------- ---------
Supplemental cash flow information:
Interest paid $ 9 $ 9
--------- ---------
--------- ---------
Income taxes paid $ 2,313 $ 1,568
--------- ---------
--------- ---------
</TABLE>
See the accompanying notes to these condensed consolidated financial statements.
5
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MACROVISION CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared by Macrovision Corporation (the "Company") in accordance with
the rules and regulations of the Securities and Exchange Commission. Certain
information and footnote disclosures, normally included in financial
statements prepared in accordance with generally accepted accounting
principles, have been condensed or omitted in accordance with such rules and
regulations. In the opinion of management, the accompanying unaudited
condensed consolidated financial statements reflect all adjustments,
consisting only of normal recurring adjustments, necessary to present fairly
the financial position of the Company, and its results of operations and cash
flows for those periods presented. This quarterly report on Form 10-QSB
should be read in conjunction with the audited financial statements and notes
thereto for the year ended December 31, 1997, and other disclosures,
including risk factors, included in the Company's Registration Statement on
Form S-3 (Registration No. 333-55757) and in the Company's Annual Report on
Form 10-KSB filed on March 30, 1998.
The results of operations for the interim periods presented are not
necessarily indicative of the results expected for the entire year ending
December 31, 1998 or any other future interim period, and the Company makes
no representations related thereto.
NOTE 2 - CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
The Company considers all highly liquid investments with a maturity from the
date of purchase of three months or less to be cash equivalents.
Investments held by the Company are classified as "available-for-sale" and
are carried at fair value based on quoted market prices, with unrealized
gains and losses, if material, reported in stockholders' equity. Such
investments consisting of U.S. government or agency issues with an original
maturity beyond 3 months and less than 12 months are classified as short-term
investments. All marketable securities with maturities over one year are
classified as long-term marketable investment securities. Available-for-sale
securities are carried at fair value based on quoted market prices, with
unrealized gains and losses, if material, reported in stockholders' equity.
The following is a summary of available -for-sale securities (in thousands):
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
<S> <C> <C>
Cash equivalents - money market funds $ 4,135 $ 622
Investments:
Auction rate preferred stock certificates - 3,400
Government bonds 37,856 9,604
-------- ---------
37,856 13,004
-------- ---------
$ 41,991 $ 13,626
-------- ---------
-------- ---------
</TABLE>
Government bond securities totaling $17,587,000 and $1,763,000 as of
September 30, 1998 and December 31, 1997, respectively, are classified as
long-term marketable investment securities.
The difference between the fair value and the amortized cost of
available-for-sale securities was $73,000 and $4,000 as of September 30, 1998
and December 31, 1997, respectively, which has been recorded under
"Accumulated other comprehensive loss" as a component in stockholders equity.
6
<PAGE>
NOTE 3 - SECONDARY OFFERING AND EXCERCISE OF OPTIONS
On June 30, 1998, the Company consummated an offering (" the offering") of
1,500,000 shares of its Common Stock, of which 1,140,000 shares were issued
and sold by the Company and 360,000 shares were sold by shareholders of the
Company. The Underwriters also exercised in full an over-allotment option to
purchase from the Company an additional 225,000 shares of Common Stock. All
shares were sold for $22.00 per share. The net proceeds to the Company from
the offering, after deducting the underwriting discount and other expenses of
the offering, were approximately $27.9 million. Proceeds from the offering
were received in July 1998. The Company did not receive any proceeds from
the sale of shares sold by the selling stockholders.
During the quarter ended September 30, 1998, the Company issued 16,795 shares
of common stock and received proceeds of approximately $47,000 associated
with the exercise of stock options. Also during the quarter ended September
30, 1998, the Company issued 20,540 shares of common stock under the Employee
Stock Purchase Plan and received proceeds of approximately $162,000.
NOTE 4 - INVENTORIES
Inventories are stated at the lower of first-in, first-out cost or market and
consisted of the following:
<TABLE>
<CAPTION>
(In thousands) September 30, December 31,
1998 1997
------------- ------------
<S> <C> <C>
Raw materials $ 113 $ 203
Work-in-process 66 -
Finished goods 223 230
------ ------
$ 402 $ 433
------ ------
------ ------
</TABLE>
NOTE 5 - NET INCOME PER SHARE
Basic earnings per share ("EPS") is computed using the weighted average
number of common shares outstanding during the period. Diluted EPS is
computed using the weighted average number of common and potentially dilutive
common shares outstanding during the period. Potentially dilutive common
shares consist of common stock issuable upon exercise of stock options using
the treasury stock method. Common shares issuable upon conversion of
preferred stock have been excluded from the computation of diluted EPS, prior
to their conversion into common stock on March 17, 1997, because the effect
of their inclusion would be antidilutive. The following is a reconciliation
of the shares used in the computation of basic and diluted EPS (in thousands):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
------- ------ ------ ------
<S> <C> <C> <C> <C>
Basic EPS - weighted average
number of common shares
outstanding 8,692 7,145 7,750 6,243
Effect of dilutive common shares -
stock options outstanding 554 530 532 495
----- ----- ----- -----
Diluted EPS - weighted average
number of common shares and
common shares outstanding 9,246 7,675 8,282 6,738
----- ----- ----- -----
----- ----- ----- -----
</TABLE>
7
<PAGE>
NOTE 6 - RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, REPORTING COMPREHENSIVE INCOME. SFAS No. 130 establishes standards
of reporting and display of comprehensive income and its components of net
income and "other comprehensive income" in a full set of general purpose
financial statements. "Other comprehensive income" refers to revenues,
expenses, gains and losses that are not included in net income but rather are
recorded directly in stockholders' equity. SFAS No. 130 is effective for
annual and interim periods beginning after December 15, 1997 and for periods
ended before that date when presented for comparative purposes. The Company
has not yet determined the format it will use to display the information
required by SFAS No. 130 in the financial statements for the year ending
December 31, 1998. Total comprehensive income was $4,103,000 and $2,315,000
for the nine months ended September 30, 1998 and 1997, respectively. The
primary components of other comprehensive income include unrealized gains and
losses resulting from the translation of the Company's foreign subsidiaries
which have a local functional currency and unrealized holding gains and
losses related to the Company's short and long term marketable investments.
In June 1997, the FASB issued SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN
ENTERPRISE AND RELATED INFORMATION. SFAS No. 131 establishes standards of
reporting information about operating segments in annual financial statements
by public business enterprises and requires such enterprises to report
selected information about operating segments in interim financial reports.
SFAS No. 131 is effective for fiscal years beginning after December 15, 1997,
and for periods ended before that date when presented for comparative
purposes. The required interim disclosures are not required to be made in
the initial year of application but the information for the interim periods
for the initial year is required as comparative information in the second
year of application. As such, the Company intends to display the information
required by SFAS No. 131 in the interim and annual financial statements for
the year ending December 31, 1999.
NOTE 7 - OTHER ASSETS
In February 1998, Macrovision acquired 247,500 shares (approximately 19.8%)
of the common stock of C-Dilla, Limited, a UK company ("C-Dilla"), for a
purchase price of $3,553,000. In February 1998, the Company also entered
into a Software Marketing License and Development Agreement under which it
has obtained, for an initial five-year term, the worldwide exclusive license
to market, in the consumer multimedia software market, C-Dilla's proprietary
copy protection technology for CD-ROM and internet-delivered software
products. The Company paid $1,015,000 in up-front license fees subject to
offset against future royalties and will pay royalty payments to C-Dilla of
between 30% to 45% of revenues from sales of software products incorporating
C-Dilla's technology. During the quarter ended September 30, 1998, the
Company recorded revenue under this arrangement of $123,000 and cost of sales
of $93,000 of which $70,000 offset the prepayment of royalties to C-Dilla.
During the quarter ended September 30, 1998, the Company invested $500,000 in
Command Audio Corporation ("CAC") in connection with a round of external
third-party financing obtained by CAC. This investment by Macrovision was
less than 19.8% of the total investment financing made and thus reduced
Macrovision's previous 19.8% ownership of CAC. Subsequently, CAC paid in full
a note due Macrovision including accrued interest.
The Company intends to hold its investments for the long term and monitors
whether there has been an other than a temporary decline in the value of
these investments based on management's estimates of their net realizable
value taking into account the achievement of milestones in business plans and
third-party financing. The Company records its investments using the cost
method and such investments are classified as other assets in the
accompanying condensed consolidated balance sheets as follows:
8
<PAGE>
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
<S> <C> <C>
Investment in CAC $ 2,837 $ 2,337
Investment in Digimarc 1,500 1,500
Investment in C-Dilla 3,553 --
Prepayment of royalties to C-Dilla 945 --
Deposits and other assets 172 163
-------- ---------
$ 9,007 $ 4 ,000
-------- ---------
-------- ---------
</TABLE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE
MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION
21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. PREDICTIONS OF
FUTURE EVENTS ARE INHERENTLY UNCERTAIN. ACTUAL EVENTS COULD DIFFER MATERIALLY
FROM THOSE PREDICTED IN THE FORWARD-LOOKING STATEMENTS AS A RESULT OF THE
RISKS SET FORTH IN THIS FORM 10-QSB AND IN THE "RISK FACTORS" SECTION OF THE
COMPANY'S PROSPECTUS DATED JUNE 25, 1998, INCLUDED IN THE COMPANY'S
REGISTRATION STATEMENT ON FORM S-3 (REGISTRATION NO. 333-55757), WHICH WAS
DECLARED EFFECTIVE BY THE SECURITIES AND EXCHANGE COMMISSION ON JUNE 25,1998.
THERE ARE NO ASSURANCES THAT THE COMPANY HAS IDENTIFIED ALL POSSIBLE
PROBLEMS THAT THE COMPANY MIGHT FACE. ALL INVESTORS SHOULD CAREFULLY READ
THE COMPANY'S REGISTRATION STATEMENT ON FORM S-3 AND ANNUAL REPORT ON FORM
10-KSB, TOGETHER WITH THIS FORM 10-QSB, AND CONSIDER ALL SUCH RISKS BEFORE
MAKING AN INVESTMENT DECISION WITH RESPECT TO THE COMPANY'S STOCK.
OVERVIEW
The Company was founded in 1983 to develop video security solutions for major
motion picture studios and independent video producers. Since that time, the
Company has derived most of its revenues and operating income from licensing
its video copy protection technologies. The revenues of the Company
primarily consists of licensing fees for videocassette and DVD copy
protection, licensing of digital Pay-Per-View copy protection, licensing fees
for multimedia software copy protection and licensing and selling products
incorporating its PhaseKrypt video scrambling technology to cable television
system operators, law enforcement agencies, television broadcasters and
private analog satellite networks.
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 1997
The following table provides revenue information by general product lines for
the three-month period ended as indicated (dollars in thousands):
<TABLE>
<CAPTION>
September 30, September 30,
1998 % 1997 % % Change
------------- ---- ------------- --- --------
<S> <C> <C> <C> <C> <C>
Copy Protection Group $ 6,018 95 $ 4,647 92 30%
Video Scrambling Group 166 3 340 7 (51)%
Multimedia 123 2 -- -- --
Other -- -- 53 1 --
-------- --- -------- ---
Total $ 6,307 100 $ 5,040 100 25%
-------- --- -------- ---
-------- --- -------- ---
</TABLE>
NET REVENUES
Consolidated net revenues for the third quarter of 1998 increased 25% to $6.3
million from $5.0 million in the third quarter of 1997. Revenues from the
Copy Protection Group increased 30% to $6.0 million from $4.6 million.
Within this group, revenue from videocassettes was $4.2 million in 1998
compared to $3.5
9
<PAGE>
million in 1997 due to royalties from the higher volume of videocassettes
from studio business and in particular, the production of the movie
"Titanic". DVD revenue was $813,000 in 1998 compared to $320,000 due to
increases in DVD replication as the market place expands with increased DVD
players and retail outlets distributing the product. Pay-per-view revenue
was $1.1 million in 1998 compared to $838,000 in 1997 due to continued
increases in the shipments of set-top boxes as the subscriber base grows in
the direct broadcast satellite (DBS) market. Revenues from the Video
Scrambling Group decreased 51% to $166,000 from $340,000. Within the Video
Scrambling Group the overall demand for VES products from various government
law enforcement agencies continues to be low, revenues for the third quarter
of 1998 was slightly higher than the lower levels of the third quarter of
1997. This increase was more than offset by decreases for analog decoding
equipment, primarily due to the Southeast Asian financial situation, which
has delayed expected cable TV system upgrades and, consequently, limited the
ability of the Company's licensees' to sell addressable set-top converters
that include the Company's PhaseKrypt TM scrambling technology. The Company
recorded its first multimedia revenues in the third quarter of 1998
associated with the software copy protection of computer CD-ROMs involving
three titles from three customers.
GROSS MARGIN
Gross margin for the third quarter of 1998 was the same as the third quarter
of 1997 at 91%. Cost of revenues was affected in absolute dollars for the
third quarter of 1998 compared to the third of 1997 by higher royalty fees,
patent defense costs and unabsorbed overhead offset slightly by lower patent
amortization and hardware costs. Cost of revenues includes items such as
product costs, duplicator fees, processor costs, patent amortization and
royalty expense. As revenues increase from multimedia software copy
protection, gross margin may decrease due to the higher cost of sales
associated with the royalties and other costs.
RESEARCH AND DEVELOPMENT
Research and development expenses increased by $141,000 or 26% in the third
quarter of 1998 compared to the third quarter of 1997. Research and
development expenses remained constant as a percentage of net revenues at
11%. The actual dollar increase was primarily due to higher compensation and
benefit expenses from additional personnel. Research and development
expensese may increase as the Company expands into new technologies and
products.
SELLING AND MARKETING
Selling and marketing expenses decreased by $118,000 or 8% in the third
quarter of 1998 compared to the third quarter of 1997 primarily due to lower
professional fees and the reduction of sales efforts associated with
Cineguard offset slightly by higher compensation and benefit expenses
associated with additional personnel. Selling and marketing expenses
declined as a percentage of net revenues from 29% in the third quarter of
1997 to 21% in the third quarter of 1998. Selling and marketing expenditures
are expected to increase as the Company begins its efforts in selling and
marketing of the Safedisc and other new products.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased by $93,000 or 9% in the third
quarter of 1998 compared to the third quarter of 1997 primarily due to the
reversal of sales tax expense of $122,000 due to a favorable judicial ruling
in a tax case which lowered the Company's expenses on a one-time basis in the
third quarter of 1997. General and administrative expenses declined as a
percentage of net revenues from 20% in the third quarter of 1997 to 18% in
the third quarter of 1998.
INTEREST AND OTHER INCOME
Other income increased by $244,000 or 177% in the third quarter of 1998
compared to the third quarter of 1997 primarily from interest income received
on the proceeds of the Company's secondary public stock offering received in
early July 1998 and miscellaneous income.
10
<PAGE>
INCOME TAXES
Income tax expense represents combined federal and state taxes at an
effective rate of 38% for each quarter ended September 30, 1998 and 1997.
NET INCOME
Net income for the third quarter of 1998 was $1,810,000 compared to
$1,048,000 in the third quarter of 1997.
NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED SEPTEMBER
30, 1997
The following table provides revenue information by general product lines for
the nine-month period ended as indicated (dollars in thousands):
<TABLE>
<CAPTION>
September 30, September 30,
1998 % 1997 % % Change
------------- ---- ------------- --- --------
<S> <C> <C> <C> <C> <C>
Copy Protection Group $ 15,880 92 $ 12,223 85 30%
Video Scrambling Group 1,147 7 1,970 14 (42)%
Multimedia 123 1 -- -- --
Other -- -- 133 1 --
--------- --- --------- ---
Total $ 17,150 100 $ 14,326 100 20%
--------- --- --------- ---
--------- --- --------- ---
</TABLE>
NET REVENUES
Consolidated net revenues for the first nine months of 1998 increased 20% to
$17.2 million from $14.3 million for the first nine months of 1997. Revenues
from the Copy Protection Group increased 30% to $15.9 million from $12.2
million. Within this group, revenue from videocassettes was $11.0 million in
1998 compared to $9.0 million in 1997 due to the higher volumes of
videocassettes from studio business and in particular the production of the
movie "Titanic". DVD revenue was $2.1 million in 1998 compared to $603,000
in 1997 due to the increases in DVD replication as the marketplace expands
compared to last year with increased DVD players and retail outlets carrying
the product. Copy protection revenue for 1998 also includes the entrance of
DIVX into the market. Increases in licensing fees from PC subassembly
manufacturers and the licensing fee from DIVX also contributed to the
increased revenue in the first nine months of 1998 over the first nine months
of 1997. Pay-per-view revenue was $2.8 million in 1998 compared to $2.7
million in 1997. Pay-per-view revenue is comprised of license fees,
royalties on set-top boxes and usage fees from operators. Higher set-top box
revenue in 1998 was offset by lower license fees from manufacturers and
operators entering the market. Revenues from the Video Scrambling Group
decreased 42% to $1.1 million from $2.0 million due to the continued
decreased demand for VES products from various government law enforcement
agencies and decreases in demand for cable TV addressable analog set-top
decoders primarily due to the Southeast Asian financial situation which has
delayed expected cable TV system upgrades and, consequently, reduced the
ability of the Company's licensees' to sell addressable set-top converters
that include the Company's PhaseKrypt TM scrambling technology. The Company
recorded its first multimedia revenues of $123,000 in the third quarter of
1998 associated with the software copy protection of computer CD-ROMs.
GROSS MARGIN
Gross margin for the nine months ended September 30, 1998 was 92% compared
to 87% for the comparable period of 1997. The Company's gross margin is
influenced by its sales mix, which in 1998 benefited from increased license
fees and higher margin royalty based revenue and reduced levels of lower
margin scrambling product sales and reduced by royalties payable for the
multimedia revenue. Cost of revenues was affected in absolute dollars for the
nine months ended September 30, 1998 compared to the nine months ended
September 30, 1997 by higher patent defense costs, unabsorbed overhead and
royalty expense offset
11
<PAGE>
by lower patent amortization, hardware costs and processor costs. Cost of
sales includes items such as product costs, duplicator fees, processor costs,
patent amortization and royalty expense. As revenues increase from
multimedia software copy protection, gross margin may decrease due to the
higher cost of sales associated with the royalties and other costs.
RESEARCH AND DEVELOPMENT
Research and development expenses increased by $345,000 or 21% during the
first nine months of 1998 compared to the same period in 1997 primarily due
to higher compensation and benefit expenses from additional personnel and
travel offset in part by lower engineering project supplies. Research and
development expenses remained constant at approximately 11% of net revenues
for 1998 and 1997. The actual dollar expenditure in research and development
may increase as the Company expands into new technologies and products.
SELLING AND MARKETING
Selling and marketing expenses decreased by $31,000 or 1% during the first
nine months of 1998 compared to the same period in 1997. Selling and
marketing expenses declined as a percentage of net revenues to 25% for the
nine months ended September 30, 1998 from 31% for the nine months ended
September 30, 1997. Selling and marketing expenditures are expected to
increase as the Company begins its efforts in selling and marketing of the
Safedisc and other new products.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased by $483,000 or 17% during the
first nine months of 1998 compared to the same period in 1997. These
expenses remained constant as a percentage of net revenues at 20%. This
increase was primarily due to increased compensation and benefits associated
with increased personnel and the reversal of sales tax expense made possible
under a favorable judicial ruling in a tax case which lowered the Company's
expenses on a one-time basis in 1997 offset slightly by lower legal costs.
INTEREST AND OTHER INCOME
Other income during the first nine months of 1998 increased $374,000 or 120%
compared to the same period in 1997 primarily as a result of interest income
on the proceeds of the Company's initial public offering in March 1997, the
proceeds from the Company's secondary stock offering received in early July
1998 and, to a lesser extent, from miscellaneous income.
INCOME TAXES
Income tax expense represents combined federal and state taxes at effective
rates of 38% and 39% for the nine months ended September 30, 1998 and 1997,
respectively. The lower rate for 1998 was due to higher tax exempt interest
earned in 1998.
NET INCOME
Net income for the nine months ended September 30, 1998 was $4.1 million
compared to $2.4 million for the first nine months of 1997.
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its operations primarily from cash generated by
operating activities, principally by its copy protection business. The
Company's operating activities provided net cash of $5.1 million and $2.2
million for the nine months ended September 30, 1998 and 1997, respectively.
For the first nine months of 1998, net cash was provided primarily by net
income, noncash charges, the payment of a note due from a related party and
an increase in deferred revenue offset slightly by an increase in accounts
receivable. For the first nine months of 1997, net cash was provided
primarily by net income before noncash charges
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and an increase in deferred revenue and income taxes payable offset by an
increase in accounts receivable and decreases in accounts payable and accrued
expenses.
Investing activities used cash of $30.2 million and $13.8 million in the nine
months ended September 30, 1998 and 1997, respectively. For the first nine
months of 1998, net cash used in investing activities was primarily the
investment of the proceeds from the secondary offering, an investment in and
payment of royalties to C-Dilla and an additional investment in CAC. The
Company accounts for the investment in C-Dilla and CAC using the cost method.
The Company also made capital expenditures of $210,000 and $484,000 in the
nine months ended September 30, 1998 and 1997, respectively. In addition,
the Company paid $512,000 and $223,000 in the nine months ended September 30,
1998 and 1997, respectively, for costs associated with obtaining patents and
other intangibles.
For the nine months ended September 30, 1998, the Company had net cash
provided from financing activities of $28.4 million relating primarily to
the net proceeds from the secondary stock offering and, to a lesser extent,
the issuance of common stock upon the exercise of stock options and under the
Company's stock purchase plan. For the nine months ended September 30, 1997,
the Company received net cash of $14.1 million from its initial public
offering, which represented substantially all of the cash provided by
financing activities in that period. On June 30, 1998, the Company
consummated an offering of 1,500,000 shares of its Common Stock, of which
1,140,000 shares were issued and sold by the Company and 360,000 shares were
sold by existing stockholders of the Company. The Underwriters also
exercised in full an over-allotment option to purchase from the Company an
additional 225,000 shares of Common Stock. All shares were sold for $22.00
per share. The net proceeds to the Company from the offering, after deducting
the underwriting discount and other expenses of the offering, were
approximately $27.9 million. The Company did not receive any proceeds from
the sale of shares sold by the selling shareholders. The Company received
the proceeds from the offering in July 1998.
At September 30, 1998, the Company had $4.6 million in cash and cash
equivalents, $20.3 million in short-term investments and $17.6 million in
long-term marketable investment securities. The Company had no material
commitments for capital expenditures but anticipates that capital
expenditures for the next 12 months will aggregate approximately $400,000.
The Company also has future minimum lease payments of approximately $1.6
million under operating leases and approximately $216,000 under capital
leases. The Company believes that the remaining net proceeds of its initial
public offering and the secondary stock offering, together with available
funds and cash flows generated from operations, will be sufficient to meet
its working capital and capital expenditure requirements for the foreseeable
future. The Company may also utilize cash to acquire or invest in businesses
or to obtain the right to use certain technologies.
ITEM 3. RISK FACTORS.
FLUCTUATIONS IN FUTURE OPERATING RESULTS; SEASONALITY. The Company's
operating results have fluctuated in the past, and are expected to continue
to fluctuate in the future, on an annual and quarterly basis as a result of
a number of factors. Such factors include, but are not limited to, the
timing of release of popular motion pictures, such as Titanic in the quarter
ended September 30, 1998, on videocassettes or DVDs or by digital PPV
transmission, the degree of acceptance of the Company's copy protection
technologies by major motion picture studios, the mix of products sold and
technologies licensed, any change in product or license pricing, the
seasonality of revenues, changes in the Company's operating expenses,
personnel changes, the development of the Company's direct and indirect
distribution channels, foreign currency exchange rates and general economic
conditions. The Company may choose to reduce prices or increase spending in
response to competition or new technologies or elect to pursue new market
opportunities. If new competitors, technological advances in the industry or
by existing or new competitors or other competitive factors require the
Company to invest significantly greater resources in research and development
or marketing efforts, the Company's future operating results may be
adversely affected. Because a high percentage of the Company's operating
expenses is fixed, a small variation in the timing of recognition of revenues
can cause significant variations in operating results from period to period.
The Company has experienced significant seasonality in its business, and the
Company's financial condition and results of operations are likely to be
affected by seasonality in the future. The Company has typically
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experienced its highest revenues in the fourth quarter of each calendar year
followed by lower revenues and operating income in the first quarter, and at
times in subsequent quarters, of the next year. The Company believes that
this trend has been principally due to the tendency of certain of the
Company's customers to release their more popular motion pictures on
videocassettes and DVDs during the year-end holiday shopping season. The
Company anticipates that revenues from multimedia CD-ROM copy protection will
also reflect this seasonal trend. In addition, revenues have tended to be
lower in the summer months, particularly in Europe.
Based upon the factors enumerated above, the Company believes that its
quarterly and annual revenues, expenses and operating results could vary
significantly in the future and that period-to-period comparisons should not
be relied upon as indications of future performance. There can be no
assurance that the Company will be able to grow in future periods or that it
will be able to sustain its level of net revenues or its rate of revenue
growth on a quarterly or annual basis. It is likely that, in some future
quarter, the Company's operating results will be below the expectations of
stock market analysts and investors. In such event, the price of the
Company's Common Stock could be materially adversely affected. Further, the
Company may not be in a position to anticipate a decline in revenues in any
quarter until late in the quarter, due primarily to the delay inherent in
revenue reporting from licensees and replicators, resulting in a potentially
more significant level of volatility in the price of the Company's Common
Stock.
DEPENDENCE ON VIDEOCASSETTE COPY PROTECTION TECHNOLOGY AND ADVOCACY BY MAJOR
MOTION PICTURE STUDIOS. The Company currently derives a substantial majority
of its net revenues and operating income from fees for the application of its
patented video copy protection technology to prerecorded videocassettes of
motion pictures and other copyrighted materials that are sold or rented to
consumers. Such fees represented 75.4%, 62.0% and 64.4% of the Company's net
revenues during 1996, 1997 and the first nine months of 1998, respectively.
The Company expects these fees to account for a majority of the Company's net
revenues and operating income at least through 1998. This portion of the
Company's business has not grown significantly in recent years, and there can
be no assurance that revenues from such fees will grow significantly or at
all. Any future growth in revenues from such fees will depend on the use of
the Company's copy protection technology on a larger number of
videocassettes. In order to increase or maintain its market penetration, the
Company must continue to persuade rights owners that the cost of licensing
the technology is outweighed by the increase in revenues that the rights
owners and retailers would achieve as a result of using copy protection, such
as revenues from the release of the copy protected material and/or subsequent
revenues from other venues. In this regard, the Company's copy protection
technologies are intended to deter consumer copying and are not effective
against professional duplication and video processing equipment.
In the event that the major motion picture studios or other customers of the
Company's copy protection technology were to determine that the benefits of
using the Company's technology did not justify the cost of licensing the
technology, demand for the Company's technology would decline. Any factor
that results in a decline in demand for the Company's copy protection
technology, including a change of copy protection policy by the major motion
picture studios or a decline in sales of prerecorded videocassettes that are
encoded with the Company's copy protection technology, would have a material
adverse effect on the Company's business, financial condition and results of
operations. Moreover, the ability of the Company to expand its markets in
additional home entertainment venues such as digital PPV and DVDs will depend
in large part on the support of the major motion picture studios in
advocating the incorporation of copy protection into the hardware and network
infrastructure required to distribute such video programming. In the event
that the motion picture industry withdraws its support for the Company's copy
protection technologies or otherwise determines not to copy protect a
significant portion of prerecorded video on videocassettes or DVD or digital
PPV programs, the Company's business, financial condition and results of
operations would be materially adversely affected.
DEPENDENCE ON KEY CUSTOMERS. The Company's customer base is highly
concentrated among a limited number of customers, primarily due to the fact
that the MPAA studios dominate the motion picture industry. Historically,
the Company has derived a substantial majority of its net revenues from
relatively few customers. During 1996, revenues from the Company's three
largest customers represented 37% of the Company's net revenues and each
accounted for more than 10% of the Company's net revenues. For 1997,
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one customer accounted for 11% of the Company's net revenues. For the first
nine months of 1998, revenues from the Company's two largest customers
represented 21% of the Company's net revenues, and each accounted for more
than 10% of the Company's net revenues. The Motion Picture Association of
America ("MPAA") studios as a group accounted for 47.1%, 38.6% and 42.3% of
the Company's net revenues in 1996, 1997 and the first nine months of 1998,
respectively. The Company expects that revenues from the MPAA studios will
continue to account for a substantial portion of the Company's net revenues
for the foreseeable future. The Company has agreements with four of the MPAA
studios and PolyGram for copy protection of substantially all of their
packaged media in the United States, which agreements expire at various times
ranging from December 1998 to June 2000. The failure of any of these
customers to renew their contracts or enter into new contracts with the
Company on terms that are favorable to the Company would likely result in a
substantial decline in the Company's net revenues and operating income, and
would have a material adverse effect on the Company's business, financial
condition and results of operations. Most of the Company's other
videocassette copy protection customers license the Company's technology on
an annual contract basis or title-by-title or month-by-month. There can be no
assurance that the Company's current customers will continue to use the
Company's technology at current or increased levels, if at all, or that the
Company will be able to obtain new customers. The loss of, or any significant
reduction in revenues from, a key customer would have a material adverse
effect on the Company's business, financial condition and results of
operations.
EVOLVING MARKET FOR DVD AND DIGITAL PPV COPY PROTECTION. The Company's
future growth and operating results will depend to a large extent on the
successful introduction, marketing and commercial viability of DVDs and
digital PPV programming that utilize the Company's copy protection
technologies. A number of factors will affect the Company's ability to derive
revenues from DVD and digital PPV copy protection. These factors include the
cost and effectiveness of the Company's copy protection technology in its
various applications, the development of alternative technologies or
standards for DVD copy protection, the uncertainty in the marketplace
engendered by alternative standards for DVD and for DVD recordable devices,
the ability of the Company to obtain commitments from the motion picture
studios to require copy protection on DVD media and digital PPV transmissions
and the relative ease of copying, as well as the quality of the copies of,
unprotected video materials distributed in new digital formats. Because of
their early stages of development, demand for and market acceptance of DVD
and digital PPV, as well as demand for associated copy protection, are
subject to a high level of uncertainty. Much of the DVD and digital PPV
technology and infrastructure is unproven, and it is difficult to predict
with any assurance whether, or to what extent, these evolving markets will
grow. In this regard, the Company's future growth would be adversely affected
if DVD players and digital PPV set-top decoders that do not include the
Company's copy protection components achieve market acceptance.
Although the Company's copy protection capability is embedded in over ten
million digital set-top decoders manufactured by certain of the leading
set-top decoder manufacturers, currently only seven programmers on two direct
broadcast satellite networks in Japan, one system operator in Hong Kong and a
recently announced operator in the United Kingdom have activated copy
protection for digital PPV programming. The programmers in Japan distribute
movies and adult PPV programming, which one of the Japanese government
ministries has issued guidance that all such programming should be copy
protected. There can be no assurance that any of the MPAA studios will
require copy protection for any of their PPV motion pictures or that PPV
system operators will activate such copy protection in other digital PPV
networks outside of Japan, Hong Kong or the United Kingdom. Moreover,
consumers may react negatively to copy protected PPV programming because, to
date, they have routinely copied for later viewing analog cable and
satellite-delivered subscription television ("Pay TV") and PPV programs, as
well as free broadcast programming. In addition, there can be no assurance
that certain television sets or combinations of VCRs and television sets will
not exhibit impaired pictures while displaying a copy protected DVD or
digital PPV program. If there is consumer dissatisfaction that cannot be
managed, or if there are technical compatibility problems, the Company's
business, financial condition and results of operations would be materially
adversely affected. If the market for DVD or digital PPV copy protection
fails to develop or develops more slowly than expected, or if the Company's
solution does not achieve or sustain market acceptance, the Company's
business, financial condition and results of operations would be materially
adversely affected.
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The Company seeks to expand its copy protection business through licensing
arrangements and strategic investments. The Company and Digimarc in
collaboration with Royal Philips Electronics N.V. ("Philips") are jointly
developing a digital media copy protection solution to address the
digital-to-digital copying issues associated with the next generation of DVD
and digital videocassette recording devices. They have submitted their
proposed solution to the Copy Protection Technical Working Group ("CPTWG").
There are now three competing groups submitting proposals to the CPTWG. The
group whose digital media copy protection solution is selected by the CPTWG
will have a significant advantage in licensing its technology to video rights
owners worldwide and in working with consumer electronics manufacturers, PC
platform companies and their suppliers to implement digital-to-digital copy
protection. The IEEE 1394 transmission protocol has also been proposed as a
digital-to-digital copy protection solution. If the solution being developed
by the Company, Digimarc and Philips is not the selected solution or
otherwise is not widely adopted by studios or consumer electronics
manufacturers, the Company, Digimarc and Philips will be at a competitive
disadvantage in marketing their solution. There can be no assurance that the
solution being developed by the Company, Digimarc and Philips will be
selected as the standard by the CPTWG or that such solution will achieve
market acceptance as the market and the standards for digital-to-digital copy
protection evolve.
ENTRANCE INTO NEW MARKET. The Company has an exclusive marketing agreement
with C-Dilla for copy protection technology for CD-ROM software products in
the consumer multimedia market. The market for copy protection of CD-ROMs is
unproven. For the Company to be successful in entering this new market,
producers of multimedia CD-ROMs must accept copy protection generally and
also adopt the solution developed by C-Dilla and marketed by the Company.
There can be no assurance that copy protection of multimedia CD-ROMs will be
accepted. For example, consumers may react negatively to the introduction of
copy protected CD-ROMs if they are prohibited from copying the content of
their favorite applications or if copy protection impairs the playability of
the CD-ROM. Moreover, copy protection may not be effective on all hardware
platforms or configurations or may prove to be easily circumvented. A number
of competitors and potential competitors are developing CD-ROM copy
protection solutions. Many of these competitors and potential competitors
have substantially greater name recognition and financial, technical and
marketing resources than the Company. There can be no assurance that there
will be demand for CD-ROM copy protection or that the solution marketed by
the Company will achieve or sustain market acceptance under emerging
industry standards or will meet, or continue to meet, the changing demands of
multimedia software providers.
DEPENDENCE ON PROPRIETARY TECHNOLOGY. The Company's success is heavily
dependent upon its proprietary technologies. The Company relies on a
combination of patent, trademark, copyright and trade secret laws,
nondisclosure and other contractual provisions, and technical measures to
protect its intellectual property rights. The Company holds 41 United States
patents and has 38 United States patent applications pending. In addition,
the Company has 149 foreign patents and 265 foreign patent applications
pending. There can be no assurance that any patent, trademark or copyright
owned by the Company will not be challenged and invalidated or circumvented,
that patents will issue from any of the Company's pending or future patent
applications or that any claims in issued patents or pending patent
applications will be of sufficient scope or strength or be issued in all
countries where the Company's products can be sold or its technologies can be
licensed to provide meaningful protection or any commercial advantage to the
Company. There can be no assurance that the expiration of any of the
Company's patents will not have a material adverse effect on the Company's
business, financial condition and results of operations. Further, there can
be no assurance that others will not develop technologies that are similar or
superior to the Company's technologies, duplicate the Company's technologies
or design around the patents owned by the Company. Effective intellectual
property protection may be unavailable or limited in certain foreign
countries. Despite the Company's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy or otherwise use aspects of the
Company's processes and devices that the Company regards as proprietary.
Policing unauthorized use of the Company's proprietary information is
difficult, and there can be no assurance that the steps taken by the Company
will prevent misappropriation of its technologies. In the event that the
Company's intellectual property protection is insufficient to protect the
Company's intellectual property rights, the Company could face increased
competition in the market for its products and technologies, which could have
a material adverse effect on the Company's business, financial condition and
results of operations.
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From time to time, the Company has received claims from third parties that
the Company's technologies and products infringe the intellectual property
rights of such third parties. Krypton Co., Ltd., a Japanese company, has
filed an invalidation claim against one of the Company's anti-copy patents
in Japan. After consultation with Japanese patent counsel, the Company
believes that this claim is without merit and will aggressively contest the
claim in the Japanese Patent Office. In the event of an adverse ruling on
such claim, the Company might incur legal competition from clones of its own
copy protection technology in Japan and a corresponding decline in demand for
such technology from the Company, which could have a material adverse effect
on the Company's business, financial condition and results of operations. In
addition, as the Company acquires or licenses a portion of the technology
included in its products from third parties, its exposure to infringement
actions may increase because the Company must rely upon such third parties
for information as to the origin and ownership of such acquired or licensed
technology. Although the Company intends to obtain representations as to the
origins and ownership of such acquired or licensed software and obtain
indemnification to cover any breach of any such representations, there can be
no assurance that such representations will be accurate or that such
indemnification will provide adequate compensation for any breach of such
representations. The Company and C-Dilla have received communications from
Ablex Audio Video Limited and its subsidiary, Pan Technologies, notifying
them that these companies assert rights to the technology that C-Dilla
licenses to the Company and claiming that the Company's agreements with
C-Dilla violate understandings that these companies had allegedly reached
with C-Dilla. The Company has been informed that a number of potential
customers for the CD-ROM copy protection solution to be marketed by the
Company have received similar communications. The Company believes that these
assertions and claims are without merit. If, as threatened, these companies
commence litigation against the Company or C-Dilla or if the Company or
C-Dilla initiates litigation to establish its or their rights to the
technology, further uncertainty could develop as to the Company's rights to
the CD-ROM copy protection technology, which could impair the Company's
ability to market the technology and have a material adverse effect on the
Company's business, financial condition and results of operations. To the
extent that these or any other communications or any litigation create
further uncertainty in the marketplace, acceptance of the technology to be
marketed by the Company would be delayed, which could have a material
adverse effect on the Company's business, financial condition and results of
operations. These and any other such claims of infringement, with or without
merit, could be time consuming to defend, result in costly litigation, divert
management's attention from day-to-day operations, cause product shipment
delays or require the Company to cease utilizing the infringing technology
unless it can enter into royalty or licensing agreements. Such royalty or
licensing agreements might not be available on terms acceptable to the
Company, or at all, which could have a material adverse effect on the
Company's business, financial condition and results of operations.
The Company has nine United States and 20 foreign patents covering a number
of processes and devices that unauthorized parties could use to circumvent
the Company's copy protection technologies. The Company uses these patents to
limit the proliferation of devices intended to circumvent the Company's copy
protection technologies. The Company has initiated a number of patent
infringement disputes against manufacturers and distributors of such devices.
In the event of an adverse ruling in this type of litigation, the Company
might suffer from the legal availability of such a circumvention device or
obtain rights to the offending devices. The legal availability of
circumvention devices could result in the increased proliferation of devices
that defeat the Company's copy protection technology and a decline in demand
for the Company's technologies, which could have a material adverse effect on
the Company's business, financial condition and results of operations. On
October 30, 1998 the President of the United States signed in law Digital
Millenium Copyright Act wherein it states "within 18 months after enactment,
no person shall manufacture, import, offer to the public, provide, or
otherwise traffic in any VHS format analog videocassette recorder unless such
recorder conforms to automatic gain control technology." This and other
legislation before certain foreign legislative bodies would make such
circumvention devices illegal.
Additional litigation may be necessary in the future to limit the sale of
circumvention technologies, to enforce the Company's patents and other
intellectual property rights, to protect the Company's trade secrets, to
determine the validity and scope of the proprietary rights of others or to
defend against claims of infringement or invalidity. There can be no
assurance that any such litigation will be successful. Such litigation could
result in substantial costs, including indemnification of customers, and
diversion of
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resources and could have a material adverse effect on the Company's business,
financial condition and results of operations, whether or not such litigation
is determined adversely to the Company. In the event of an adverse ruling in
any such litigation, the Company might be required to pay substantial
damages, discontinue the use and sale of infringing products, expend
significant resources to develop non-infringing technology or obtain licenses
to infringed technology. The failure of the Company to develop or license a
substitute technology could have a material adverse effect on the Company's
business, financial condition and results of operations.
RISKS ASSOCIATED WITH STRATEGIC INVESTMENTS. The Company has recently
expanded its technological base in current as well as new markets through
strategic investments in companies with complementary or compatible
technologies or products. The Company currently holds minority equity
interests in Command Audio Corporation, Digimarc and C-Dilla Limited. Such
investments, which total $7.9 million and represented 12.5% of the Company's
total assets at September 30, 1998, involve a number of risks. The
negotiation, creation and management of these strategic relationships
typically involve a substantial commitment of management time and resources
by the Company, and there can be no assurance that the Company will ever
recover the cost of such management resources. Because these companies are
privately held, there is no active trading market for their securities, and
the Company's investments in them are illiquid. There may never be an
opportunity for the Company to realize a return on its investment in any of
these companies, and the Company may in the future be required to write off
all or part of one or more of these investments. The write-off of all or part
of one or more of these investments could have a material adverse affect on
the Company's business, financial condition and results of operations.
The Company's strategic investments typically involve joint development or
marketing efforts or technology licensing. There can be no assurance that any
joint development efforts will result in the successful introduction of new
products by the Company or a third party, or that any joint marketing efforts
will result in increased demand for the Company's products. Further, there
can be no assurance that any current or future strategic investments by the
Company will allow the Company to enter and compete effectively in new
markets or improve the Company's performance in current markets.
RISKS ASSOCIATED WITH INTERNATIONAL AND EXPORT SALES. In 1996, 1997 and the
nine months ended September 30, 1998, international and export sales together
represented 37.9%, 46.5% and 44.4%, respectively, of the Company's net
revenues. The Company expects that such sales will continue to represent a
substantial portion of its net revenues for the foreseeable future. The
Company's future growth will depend to a large extent on worldwide
deployment of addressable analog cable television systems, as well as digital
PPV programming and DVDs and the use of copy protection in these media. To
the extent that foreign governments impose restrictions on importation of
programming, technology or components from the United States, the
requirement for copy protection and video scrambling in these markets would
diminish. Any limitation on the growth of these markets or the Company's
ability to sell its products or license its technologies into these markets
would have a material adverse effect on the Company's business, financial
condition and results of operations. In particular, the net revenues that the
Company derives from video scrambling decreased 41.8% from the first nine
months of 1997 to the first nine months of 1998, due to decreased demand for
analog decoding equipment that resulted primarily from the financial crisis
in Southeast Asia. This crisis has also delayed expected cable television
system upgrades in that region and, consequently, has adversely affected the
ability of the Company's licensees to sell addressable set-top decoders that
include the Company's PhaseKrypt video scrambling technology. In addition,
the laws of certain foreign countries may not protect the Company's
intellectual property rights to the same extent as do the laws of the United
States, which increases the risk of unauthorized use of the Company's
technologies and the ready availability or use of circumvention technologies.
Such laws also may not be conducive to copyright protection of video
materials and digital media, which reduces the need for the Company's copy
protection and video scrambling technologies.
Due to its reliance on international and export sales, the Company is subject
to the risks of conducting business internationally, including foreign
government regulation and general geopolitical risks such as political and
economic instability, potential hostilities and changes in diplomatic and
trade relationships. International and export sales are subject to other
risks, such as changes in, or imposition of, regulatory requirements,
decision making control to use the Company's products by studio headquarters
operations,
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tariffs or taxes and other trade barriers and restrictions, foreign
government regulations, fluctuations in currency exchange rates,
interpretations or enforceability of local patent or other intellectual
property laws, longer payment cycles, difficulty in collecting accounts
receivable, potentially adverse tax consequences, the burdens of complying
with a variety of foreign laws, difficulty in staffing and managing foreign
operations and political and economic instability. For example, under the
United States Export Administration Act of 1979, as amended, and regulations
promulgated thereunder, encryption algorithms such as those used in the
Company's video scrambling technologies are classified as munitions and
subject to stringent export controls. Any changes to the statute or the
regulations with respect to export of encryption technologies could require
the Company to redesign its products or technologies or prevent the Company
from selling its products and licensing its technologies internationally.
While international and export sales are typically denominated in United
States dollars, fluctuations in currency exchange rates could cause the
Company's products to become relatively more expensive to customers in a
particular country, leading to a reduction in sales or profitability in that
country. There can be no assurance that the Company's future results of
operations will not be materially adversely affected by currency
fluctuations. The Company's business and operating resultscould be materially
adversely affected if foreign markets do not continue to develop, or if the
Company does not receive additional orders to supply its technologies or
products for use in foreign prerecorded video, PPV and Pay TV networks and
other applications requiring the Company's video security solutions.
YEAR 2000 ISSUES
BACKGROUND OF YEAR 2000 ISSUES
Many currently installed computer systems and software products are unable to
distinguish between twentieth century dates and twenty-first century dates
because such systems may have been developed using two digits rather than
four to determine the applicable year. For example, computer systems that
have date-sensitive software may recognize a date using "00" as the year 1900
rather than the year 2000. This error could result in system failures or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices or
engage in similar normal business activities. As a result, many companies'
software and computer systems may need to be upgraded or replaced to comply
with such "Year 2000" requirements.
STATE OF READINESS
Macrovision's business is dependent on the operation of numerous systems that
could potentially be impacted by Year 2000 related problems. Those systems
include, among others: hardware and software systems used internally by the
Company in the management of its business; the internal systems of the
Company's customers and suppliers; and non-information technology systems
and services used by the Company in the management of its business, such as
telephone systems and building systems.
Based on an analysis of the systems potentially impacted by conducting
business in the twenty-first century, the Company is applying a phased
approach to making such systems, and accordingly the Company's operations,
ready for the year 2000. Beyond awareness of the issues and scope of systems
involved, the phases of activities in progress include: an assessment of
specific underlying computer systems, programs and/or hardware; remediation
or replacement of Year 2000 non-compliant technology; validation and testing
of technologically compliant Year 2000 solutions; and implementation of the
Year 2000 compliant systems.
19
<PAGE>
The table below provides the status and timing of such phased activities:
<TABLE>
<CAPTION>
TARGETED
IMPACTED SYSTEMS STATUS IMPLEMENTATION
---------------- ------ --------------
<S> <C> <C>
Hardware and software products Assessment completed, Q1 1999
licensed or sold by the conducting validation and
Company testing
Hardware and software systems Assessment completed; certain Q1 1999
used internally by the Company components replaced;
in the management of its conducting validation and
business testing
Internal systems of the Assessment not yet completed Q3 1999
Company's customers and
suppliers;
Non-information technology Assessment completed; certain Q2 1999
systems and services used by components replaced,
the Company in the management conducting validation and
of its business, internal and testing
external, such as telephone
systems and building systems.
</TABLE>
COSTS TO ADDRESS YEAR 2000 ISSUES
The Company has expensed all costs as incurred, which to date have been
insignificant, directly related to Year 2000 issues, even in cases where
non-compliant information technology systems have been replaced. The
replacement cost of non-information technology systems would have been
incurred, regardless of the Year 2000 issue, to accommodate the growth of the
Company.
The Company does not believe that future expenditures to upgrade internal
systems and applications will have a material adverse effect on its business,
financial condition and results of operations. In addition, while the
potential costs of redeployment of personnel and any delays in implementing
other projects is not known, the costs are anticipated to be immaterial.
RISKS OF THE YEAR 2000 ISSUES
The Company believes its products are Year 2000 compliant; however, success
of the Company's Year 2000 compliance efforts may depend on the success of
its customers in dealing with their Year 2000 issues. The Company sells its
products to companies in a variety of industries each experiencing different
issues with Year 2000 compliance. Customer difficulties with year 2000 issues
could interfere with the use of the Company's products which might require
the Company to devote additional resources to resolve the underlying
problems. If the problem is found to lie in the Company's products, the
Company's business, financial condition and results of operations could be
materially adversely affected.
Furthermore, the purchasing patterns of these customers or potential
customers may be affected by Year 2000 issues as companies expend significant
resources to become Year 2000 compliant. The costs of becoming Year 2000
compliant for current or potential customers may result in reduced funds
available to purchase and implement the Company's products. In addition, the
Company relies on various entities that are common to many businesses, such
as public utilities. If these entities were to experience Year 2000 failures,
the Company's ability to conduct business would be disrupted.
CONTINGENCY PLANS
The Company has conducted an assessment of certain of its Year 2000 exposure
areas in order to determine what steps beyond those identified by the
Company's internal review were advisable and no additional work was
recommended. The Company does not presently have a contingency plan for
handling Year 2000
20
<PAGE>
problems that are not detected and corrected prior to their occurrence. Any
failure of the Company to address any unforeseen Year 2000 issue could
adversely affect the Company's business, financial condition and results of
operations.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
SWYT LITIGATION
In October 1995, Joseph Swyt, a former officer and director of the Company,
filed suit against the Company in the Superior Court of the State of
California alleging monetary damages suffered as a result of alleged fraud,
misrepresentation, and other malfeasance in connection with the Company's
grant of stock options to him. Mr. Swyt maintains that the Company induced
him to accept employment by falsely representing to him that the options
granted to him eventually would have substantial value. Between August 1990
and December 1993, the Company granted to him options to purchase
approximately 200,000 shares of the Company's Common Stock with per-share
exercise prices of $2.25 or $2.70. Substantially all of these options expired
unexercised within three months following his departure from the Company in
June 1995. In December 1996, the court ordered this matter to binding
arbitration in accordance with a written agreement between the Company and
Mr. Swyt. The arbitration agreement contains limitations on the types of
damages available to him and expressly precludes punitive damages. Mr. Swyt
filed his claim in arbitration for this matter with the American Arbitration
Association in June 1997 and arbitration hearings scheduled for October 1998
have been rescheduled for February 1999. The Company believes that the case
is without merit and intends to contest it vigorously. In the opinion of
counsel, it is not possible to determine with precision the probable outcome
or the amount of liability, if any, under this lawsuit. A decision against
the Company could have a material adverse effect on the Company's business,
financial condition and results of operations.
ITEM 5 - OTHER INFORMATION.
On August 3, 1998, the Company filed a Form S-8 to register the additional
400,000 shares reserved for issuance under the Company's 1996 Equity
Incentive Plan.
In July 1998, the Company invested an additional $500,000 as part of a round
of third-party financing obtained by CAC. Subsequently, CAC repaid its
outstanding note to the Company including accrued interest, in the amount of
$355,000.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
27.1 - 1998 Financial Data Schedule.
27.2 - 1997 Financial Data Schedule
(b) Reports on Form 8-K.
During the quarter ended September 30, 1998, the Company filed no Current
Reports on Form 8-K.
21
<PAGE>
SIGNATURES
In accordance with the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
Macrovision Corporation
Date: November 13, 1998 By: /S/ William A. Krepick
----------------- ----------------------------------------------
William A. Krepick, President and Chief
Operating Officer
Date: November 13, 1998 By: /S/ Victor A. Viegas
----------------- ----------------------------------------------
Victor A. Viegas, Vice President, Finance
and Administration and Chief Financial Officer
22
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED FINANCIAL STATEMENTS OF MACROVISION CORPORATION FOR THE NINE MONTHS
ENDED SEPTEMBER 30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 4630
<SECURITIES> 20269
<RECEIVABLES> 6260
<ALLOWANCES> 792
<INVENTORY> 402
<CURRENT-ASSETS> 33858
<PP&E> 4290
<DEPRECIATION> 2889
<TOTAL-ASSETS> 63278
<CURRENT-LIABILITIES> 6095
<BONDS> 0
0
0
<COMMON> 9
<OTHER-SE> 56252
<TOTAL-LIABILITY-AND-EQUITY> 63278
<SALES> 17150
<TOTAL-REVENUES> 17150
<CGS> 1439
<TOTAL-COSTS> 1439
<OTHER-EXPENSES> 9735
<LOSS-PROVISION> 152
<INTEREST-EXPENSE> 9
<INCOME-PRETAX> 6661
<INCOME-TAX> 2543
<INCOME-CONTINUING> 4118
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4118
<EPS-PRIMARY> .53
<EPS-DILUTED> .50
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED FINANCIAL STATEMENTS OF MACROVISION CORPORATION FOR THE NINE MONTHS
ENDED SEPTEMBER 30, 1997 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 4689
<SECURITIES> 12185
<RECEIVABLES> 4760
<ALLOWANCES> 465
<INVENTORY> 639
<CURRENT-ASSETS> 24116
<PP&E> 4590
<DEPRECIATION> 2752
<TOTAL-ASSETS> 28340
<CURRENT-LIABILITIES> 5891
<BONDS> 0
0
0
<COMMON> 7
<OTHER-SE> 21875
<TOTAL-LIABILITY-AND-EQUITY> 28340
<SALES> 14326
<TOTAL-REVENUES> 14326
<CGS> 1822
<TOTAL-COSTS> 1822
<OTHER-EXPENSES> 8938
<LOSS-PROVISION> 370
<INTEREST-EXPENSE> 9
<INCOME-PRETAX> 3877
<INCOME-TAX> 1518
<INCOME-CONTINUING> 2359
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2359
<EPS-PRIMARY> .35
<EPS-DILUTED> .33
</TABLE>
