<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2000
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number 0-24363
Interplay Entertainment Corp.
(Exact name of the registrant as specified in its charter)
Delaware 33-0102707
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
16815 Von Karman Avenue, Irvine, California 92606
(Address of principal executive offices)
(949) 553-6655
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
Class Issued and Outstanding at November 7, 2000
----- ----------------------------------------
Common Stock, $0.001 par value 30,131,352
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
FORM 10-Q
SEPTEMBER 30, 2000
TABLE OF CONTENTS
----------
<TABLE>
<CAPTION>
Page Number
-----------
<S> <C> <C>
Part I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2000 (unaudited)
and December 31, 1999 3
Consolidated Statements of Operations for the Three and Nine
Months ended September 30, 2000 and 1999 (unaudited) 4
Consolidated Statements of Cash Flows for the Nine Months
ended September 30, 2000 and 1999 (unaudited) 5
Notes to Unaudited Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk 29
Part II. Other Information
Item 1. Legal Proceedings 29
Item 5. Other Information 29
Item 6. Exhibits and Reports on Form 8-K 29
Signatures 30
</TABLE>
2
<PAGE>
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
------------- ------------
(Unaudited)
(Dollars in thousands)
<S> <C> <C>
ASSETS
------
Current Assets:
Cash $ 559 $ 399
Restricted cash -- 2,597
Trade receivables, net of allowances of $6,277 and $9,161, respectively 26,461 22,209
Inventories 4,677 6,057
Prepaid licenses and royalties 18,695 19,249
Other 1,031 874
-------- --------
Total current assets 51,423 51,385
Property and Equipment, net 5,039 4,225
Other Assets 1,040 1,326
-------- --------
$ 57,502 $ 56,936
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
----------------------------------------------
Current Liabilities:
Current debt $ 16,162 $ 19,630
Accounts payable 15,524 21,462
Accrued liabilities 14,832 17,915
-------- --------
Total current liabilities 46,518 59,007
Commitments and Contingencies
Stockholders' Equity (Deficit):
Series A Preferred stock, $.001 par value, authorized 5,000,000 shares;
issued and outstanding, 719,424 shares as of September 30, 2000 19,534 --
Common stock, $.001 par value, authorized 50,000,000 shares;
issued and outstanding 30,072,355 shares as of September 30, 2000
and 29,989,125 shares as of December 31, 1999 30 30
Paid-in-capital 88,533 87,390
Accumulated deficit (97,391) (89,782)
Accumulated other comprehensive income 278 291
-------- --------
Total stockholders' equity (deficit) 10,984 (2,071)
-------- --------
$ 57,502 $ 56,936
======== ========
</TABLE>
The accompanying notes are an integral part
of these consolidated financial statements.
3
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2000 1999 2000 1999
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
(Dollars in thousands, except per share amounts)
Net revenues $ 31,631 $ 23,636 $ 73,828 $ 74,582
Cost of goods sold 16,195 15,333 36,350 45,441
------------ ------------ ------------ ------------
Gross profit 15,436 8,303 37,478 29,141
Operating expenses:
Marketing and sales 6,212 7,304 17,617 21,763
General and administrative 2,602 8,375 7,583 14,206
Product development 5,485 5,424 16,797 16,110
Other -- 3,308 -- 4,940
------------ ------------ ------------ ------------
Total operating expenses 14,299 24,411 41,997 57,019
------------ ------------ ------------ ------------
Operating income (loss) 1,137 (16,108) (4,519) (27,878)
Other expense:
Interest expense, net 710 857 2,266 2,920
Other expense, net 314 -- 491 --
------------ ------------ ------------ ------------
Total other expense 1,024 857 2,757 2,920
Income (loss) before provision for income taxes 113 (16,965) (7,276) (30,798)
Provision for income taxes -- 11 -- 1,384
------------ ------------ ------------ ------------
Net income (loss) $ 113 $ (16,976) $ (7,276) $ (32,182)
============ ============ ============ ============
Cumulative dividend on participating preferred stock $ 200 $ -- $ 333 $ --
------------ ------------ ------------ ------------
Net loss available to common stockholders $ (87) $ (16,976) $ (7,609) $ (32,182)
============ ============ ============ ============
Net loss per common share:
Basic and diluted $ 0.00 $ (0.75) $ (0.25) $ (1.55)
============ ============ ============ ============
Weighted average number of common shares outstanding:
Basic and diluted 30,059,338 22,689,285 30,026,365 20,785,031
============ ============ ============ ============
</TABLE>
The accompanying notes are an integral part
of these consolidated financial statements.
4
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
--------------------
2000 1999
-------- --------
<S> <C> <C>
(Dollars in thousands)
Cash flows from operating activities:
Net loss $ (7,276) $(32,182)
Adjustments to reconcile net loss to
cash used in operating activities:
Depreciation and amortization 2,134 2,334
Noncash expense for stock options -- 26
Deferred income taxes -- 1,336
Minority interest in loss of subsidiary -- (74)
Changes in assets and liabilities:
Trade receivables (4,252) 13,861
Inventories 1,380 (2,942)
Prepaid licenses and royalties 554 (930)
Other current assets (157) (384)
Other assets -- 410
Accounts payable (5,938) 5,765
Accrued liabilities (3,083) (2,622)
-------- --------
Net cash used in operating activities (16,638) (15,402)
-------- --------
Cash flows from investing activities:
Purchase of property and equipment (2,662) (990)
-------- --------
Net cash used in investing activities (2,662) (990)
-------- --------
Cash flows from financing activities:
Net borrowings (payments) on line of credit (3,056) 2,483
Net proceeds from issuance of preferred stock 19,202 --
Net proceeds from issuance of common stock 323 10,300
Net proceeds from issuance of warrants 798 --
Net proceeds from issuance of notes payable -- 5,547
Payments on notes payable (375) --
Proceeds from exercise of stock options 21 8
(Additions) reductions to restricted cash 2,597 (1,567)
Payments on other debt (37) --
-------- --------
Net cash provided by financing activities 19,473 16,771
-------- --------
Effect of exchange rate changes on cash and cash equivalents (13) (87)
-------- --------
Net increase (decrease) in cash and cash equivalents 160 292
Cash and cash equivalents, beginning of period 399 614
-------- --------
Cash and cash equivalents, end of period $ 559 $ 906
======== ========
Supplemental cash flow information:
Cash paid for:
Interest $ 2,303 $ 2,607
Income taxes -- --
======== ========
Supplemental disclosures of Noncash transactions:
Accretion of preferred stock to redemption value $ (333) $ --
Issuance of common stock in exchange for rights
to intellectual properties -- 1,000
Issuance of note payable in exchange for put rights -- 1,000
======== ========
</TABLE>
The accompanying notes are an integral part
of these consolidated financial statements.
5
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Basis of Presentation
The accompanying interim consolidated financial statements of Interplay
Entertainment Corp. and its subsidiaries (the "Company") are unaudited and
reflect all adjustments (consisting only of normal recurring adjustments) that,
in the opinion of management, are necessary for a fair presentation of the
results for the interim period in accordance with instructions for Form 10-Q and
Rule 10-01 of Regulation S-X. Accordingly, they do not include all information
and footnotes required by generally accepted accounting principles in the United
States for complete financial statements. The results of operations for the
current interim period are not necessarily indicative of results to be expected
for the current year or any other period.
These consolidated financial statements should be read in conjunction with
the consolidated financial statements and notes thereto included in the
Company's annual report on Form 10-K for the year ended December 31, 1999 as
filed with the Securities and Exchange Commission.
Use of Estimates
----------------
The preparation of financial statements in conformity with generally
accepted accounting principles in the United States requires management 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 revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Reclassifications
-----------------
Certain reclassifications have been made to the prior period's financial
statements to conform to classifications used in the current period.
Revenue Recognition
-------------------
Revenues are recorded when products are delivered to customers in
accordance with Statement of Position ("SOP") 97-2, "Software Revenue
Recognition". For those agreements that provide the customers the right to
multiple copies in exchange for guaranteed amounts, revenue is recognized at the
delivery of the product master or the first copy. Per copy royalties on sales
that exceed the guarantee are recognized as duplicated. The Company is generally
not contractually obligated to accept returns, except for defective, shelf-worn
and damaged products in accordance with negotiated terms. However, the Company
permits customers to return or exchange product and may provide price protection
on products unsold by a customer. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 48, "Revenue Recognition when Right of Return
Exists", revenue is recorded net of an allowance for estimated returns,
exchanges, markdowns, price concessions, and warranty costs. Such reserves are
based upon management's evaluation of historical experience, current industry
trends and estimated costs. The amount of reserves is an estimate and the amount
ultimately required could differ materially in the near term from the amounts
included in the accompanying consolidated financial statements. Customer support
provided by the Company is limited to telephone and Internet support. These
costs are not material and are charged to expense as incurred.
Recent Accounting Pronouncements
--------------------------------
In December 1999, the Securities Exchange Commission ("SEC") staff
released Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition," as
amended by SAB No. 101A and SAB No. 101B, to provide guidance on the
recognition, presentation and disclosure of revenue in financial statements. SAB
No. 101 explains the SEC staff's general framework for revenue recognition,
stating that certain criteria be met in order to recognize revenue. SAB No. 101
also addresses the question of gross versus net revenue presentation and
financial statement and
6
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Management's Discussion and Analysis disclosures related to revenue recognition.
The Company adopted SAB No. 101 effective January 1, 2000 and the adoption of
this standard reduced net sales and cost of sales by approximately $0.2 million
and $1.7 million for the three and nine months ended September 30, 2000,
respectively, but did not have an impact on the Company's gross profit or net
income (loss). The Company did not apply this standard to the 1999 period as the
impact would have been immaterial to the financial statements taken as a whole.
Factors Affecting Future Performance
------------------------------------
For the nine months ended September 30, 2000, the Company incurred a net
loss of $7.3 million and used cash in operating activities of $16.6 million.
However, the Company's liquidity has improved substantially during the nine
months ended September 30, 2000. At September 30, 2000, the Company had positive
working capital of $4.9 million compared to a negative $7.6 million at December
31, 1999.
To provide working capital to support the Company's operations, the Company
extended its line of credit through April 2001, in connection with which Titus
Interactive SA ("Titus") provided a $20 million corporate guarantee. The Company
also completed a transaction with Titus, which provided for the issuance of
convertible, redeemable Preferred Stock for $20 million. In addition, Titus may
be entitled to receive additional shares of Common Stock upon conversion of
their Preferred Stock if the Company defaults on its line of credit and Titus is
obligated to pay on its $20 million corporate guarantee. In addition, the
Company secured a $5 million supplemental line of credit with Titus expiring in
May 2001 (see Note 3). However, the Company has been notified by Titus that they
believe that they are no longer obligated to provide funding under the $5
million line of credit.
The Company believes that funds available under its lines of credit, funds
received from the sale of equity securities and anticipated funds from
operations, if any, should be sufficient to satisfy the Company's projected
working capital and capital expenditure needs in the normal course of business
at least through the expiration of its line of credit in April 2001 (see Note
3). The Company believes that it will be able to replace its line of credit or
obtain alternative financing on reasonable terms. However, there can be no
assurance that the Company will be able to raise sufficient funds to satisfy its
projected working capital and capital expenditure needs beyond April 2001.
In addition to the risks related to the Company's liquidity discussed
above, the Company also faces numerous other risks associated with its industry.
These risks include fluctuations in operating results, dependence on new product
introductions, product completion and release delays, rapidly changing
technology, intense competition, dependence on distribution channels and the
risk of customer returns. Certain additional risks are discussed on pages 18-28
of this Quarterly Report on Form 10-Q.
The Company's consolidated financial statements have been presented on the
basis that it is a going concern. However, the Company's independent public
accountant has informed the Company that if the Company is unable to replace its
lines of credit with its current financial institution and Titus or obtain
alternative debt or equity financing sufficient to cover its operating cash flow
requirements through December 31, 2001 and beyond, or to adequately address the
issues described above, that it is likely that it will render a modified report
for going concern on the Company's financial statements as of December 31, 2000.
7
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 2. Inventories
Inventories consist of the following:
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
------------- --------------
(Dollars in thousands)
<S> <C> <C>
Packaged software $3,578 $4,394
CD-ROMs, cartridges, manuals, packaging and supplies 1,099 1,663
------ ------
$4,677 $6,057
====== ======
</TABLE>
Note 3. Current Debt
Current debt consists of the following:
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
------------- ------------
(Dollars in thousands)
<S> <C> <C>
Loan agreement $16,162 $19,218
Other -- 412
------- -------
$16,162 $19,630
======= =======
</TABLE>
Borrowings under the Company's the Loan and Security Agreement ("Loan
Agreement") with its primary lender bear interest at LIBOR (6.62 percent at
September 30, 2000 and 6.48 percent at December 31, 1999) plus 4.87 percent
(11.49 percent at September 30, 2000 and 11.35 percent at December 31, 1999). At
September 30, 2000, the Company had $5.5 million of availability on its line of
credit with the financial institution, and had $5 million available under its
line of credit with Titus (see Notes 1 and 5). During April 2000, the Company
extended its line of credit through April 2001 generally under the same terms,
except that Titus provided a $20 million corporate guarantee. During the three
months ended September 30, 2000, the Company's financial institution received
certain financial statements from Titus and released $2.5 million of restricted
cash previously held as collateral. The Company is currently in compliance with
the terms of the Loan Agreement.
In April 2000, the Company secured a $5 million supplemental line of credit
with Titus expiring in May 2001. Amounts borrowed under this line will be
subject to interest at the maximum legal rate for parties other than financial
institutions, currently 10 percent per annum, payable quarterly (See Notes 1 and
5). In connection with this line of credit, Titus received a warrant for up to
100,000 shares of the Company's Common Stock at $3.79 per share that will expire
in April 2010 and is exercisable if and to the extent that the Company borrows
under the line of credit, as defined. The Company has been notified by Titus,
our principal stockholder, that they believe that they are no longer obligated
to fund the $5 million line of credit they extended in April 2000. No amounts
have been borrowed under this line of credit.
Note 4. Commitments and Contingencies
The Company and the former owner of Shiny Entertainment ("Shiny") have a
dispute over additional cash payments upon the delivery and acceptance of
interactive entertainment software titles that Shiny was committed to deliver
over time. The Company believes that no amounts are due as of September 30, 2000
under the applicable agreements.
Virgin Interactive Entertainment Limited ("Virgin") has disputed the
amendment to the International Distribution Agreement with the Company, and
claims that the Company is obligated, among other things, to pay a contribution
to their overhead of up to approximately $9.3 million annually, subject to
decrease by the amount of commissions earned by Virgin on its distribution of
our products. The Company believes that the amendment is legally binding and
will vigorously defend its position. However, the Company cannot assure you that
it will be successful in its defense.
8
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 5. Stockholders' Equity
In April 2000, the Company completed a $20 million transaction with Titus
under a Stock Purchase Agreement and issued 719,424 shares of newly designated
Series A Preferred Stock ("Preferred Stock") and a warrant for 350,000 shares of
the Company's Common Stock, which has preferences under certain events, as
defined. The Preferred Stock is convertible by Titus, redeemable by the Company,
and accrues a 6 percent cumulative dividend per annum payable as declared by the
Company's Board of Directors. The Company may redeem the Preferred Stock shares
at the original issue price at any time after termination of Titus's guarantee
of the Company's principal line of credit. Titus may convert the Preferred Stock
shares into shares of Common Stock at any time after May 2001 or earlier under
certain events as defined. The conversion rate is the lesser of $2.78 (7,194,240
shares of Common Stock) or 85 percent of the market price per share at the time
of conversion, as defined. The Preferred Stock is entitled to the same voting
rights as if it had been converted to Common Stock shares subject to a maximum
of 7,619,047 votes. In October 2000, the Company's stockholders approved the
issuance of the Preferred Stock to Titus. In connection with this transaction,
Titus received a warrant for 350,000 shares of the Company's Common Stock at
$3.79 per share exercisable at anytime. The fair value of the warrant was
estimated on the date of the grant using the Black-Scholes pricing model with
the following weighted average assumptions: dividend yield of zero percent;
expected volatility of 92 percent; risk-free interest rate of 5.85 percent; and
an expected life of one-year. This resulted in the Company allocating
$19,202,000 to the Preferred Stock and $798,000 to the warrant. The value of the
warrant is being accreted over a one-year period as a dividend to the Preferred
Stock. As of September 30, 2000, the Company had accreted $333,000. In addition,
Titus received a warrant for 50,000 shares of the Company's Common Stock at
$3.79 per share which would only be exercisable by Titus if the Company does not
meet certain financial operating performance targets for the year ending
December 31, 2000, as defined. Both warrants expire in April 2010.
In connection with the $20 million corporate guarantee provided by Titus on
the extension of the Company's line of credit, if the Company defaults on the
line of credit agreement, and Titus is forced to pay on its corporate guarantee
of such line, the Series A Preferred Stock conversion rights will be adjusted so
as to make such shares convertible into up to approximately 42.8 million shares
of Common Stock. In the event that the Company is able to repay to Titus the
amounts paid under the guarantee within six months, the conversion rate shall be
returned to the level at which it existed prior to such adjustment. In the event
that the Company is unable to repay such amounts within six months, the
conversion rate shall be readjusted at the end of such six month period based on
the average closing price of the Company's Common Stock for the last 20 trading
days during such period. If such average price is $10.00 per share, the shares
would be convertible into 7,194,240 shares of Common Stock, and if less than
$10.00, the shares would be convertible into approximately an additional
5,000,000 shares for each dollar the average price is below $10.00, up to a
maximum of approximately 42.8 million shares. The Common Stock shares issuable
upon conversion of the Preferred Stock or the exercise of the warrants are
subject to certain registration rights.
The Company also secured a $5 million supplemental line of credit with
Titus expiring in May 2001 (See Notes 1 and 3). Amounts drawn on this line will
be subject to interest at the maximum legal rate for parties other than
financial institutions, currently 10 percent per annum, payable quarterly. In
connection with this line of credit, Titus received a warrant for up to 100,000
shares of the Company's Common Stock at $3.79 per share that will expire in
April 2010 and is exercisable if and to the extent that the Company borrows
under the line of credit, as defined. The Company has been notified by Titus,
our principal stockholder, that they believe that they are no longer obligated
to fund the $5 million line of credit they extended in April 2000. No amounts
have been borrowed under this line of credit.
9
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 6. Other Operating Expenses
The Company recorded an asset valuation, restructuring charge and
severance expense of $0.6 and $2.3 million during the three and nine months
ended September 30, 1999, respectively, in connection with the reductions in the
Company's European operations. The Distribution Agreement with Virgin
required the Company to pay certain minimum operating charges in 1999 and the
Company has recorded a provision of $2.7 million charged to operations in the
three month period ended September 30, 1999 to cover these charges. In addition,
the Company recorded severance expense of $0.3 and $0.8 million during the three
and nine months ended September 30, 1999 respectively.
Note 7. Net Income (Loss) Per Share
Basic net income (loss) per share is calculated by dividing net income
(loss) available to common stockholders by the weighted average number of common
shares outstanding and does not include the impact of any potentially dilutive
securities. Diluted net loss per share is the same as basic net loss per share
because the effect of outstanding stock options and warrants is anti-dilutive.
The impact of the Preferred Stock conversion rights into Common Stock
shares (see Note 5) were excluded from the loss per share computation at
September 30, 2000. There were options and warrants outstanding to purchase
4,234,558 shares of Common Stock and there were 484,848 shares of restricted
Common Stock at September 30, 2000, which were excluded from the loss per share
computation. At September 30, 1999 there were options to purchase 3,224,580
shares of Common Stock, which were not included in the loss per share
computation. The weighted average exercise price of the outstanding options and
warrants at September 30, 2000 and 1999 was $2.97 and $3.46, respectively.
Note 8. Comprehensive Income (Loss)
Comprehensive income (loss) consists of the following:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ---------------------
2000 1999 2000 1999
--------- --------- --------- ---------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Net income (loss) $ 113 $(16,976) $ (7,276) $(32,182)
Other comprehensive income (loss), net of income taxes:
Foreign currency translation adjustments (16) 23 (13) 87
-------- -------- -------- --------
Total comprehensive income (loss) $ 97 $(16,953) $ (7,289) $(32,095)
======== ======== ======== ========
</TABLE>
During the three and nine months ended September 30, 2000 and 1999, the
net effect of income taxes on comprehensive income (loss) was immaterial.
Note 9. Related Parties
Distribution and Publishing Agreements
--------------------------------------
The Company amended its International Distribution Agreement with Virgin
effective January 1, 2000. Under the amended Agreement, the Company no longer
pays Virgin an overhead fee or minimum commissions. In addition, the Company
extended the term of the agreement through February 2007 and implemented an
incentive plan that will allow Virgin to earn a higher commission rate as
10
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
defined. Virgin has disputed the amendment to the International Distribution
Agreement with the Company, and claims that the Company is obligated, among
other things, to pay a contribution to their overhead of up to approximately
$9.3 million annually, subject to decrease by the amount of commissions earned
by Virgin on its distribution of our products. The Company believes that the
amendment is legally binding and will vigorously defend its position. However,
the Company cannot assure you that it will be successful in its defense. In
connection with this agreement the Company incurred distribution commission
expense of $1.1 million and $1.1 million for the three months ended September
30, 2000 and 1999, respectively, and $2.5 million and $2.1 million for the nine
months ended September 30, 2000 and 1999, respectively. In addition, the Company
recognized overhead fees of $2 million and $3.8 million for the three and nine
months ended September 30, 1999, respectively.
In connection with the Product Publishing Agreement with Virgin, the
Company earned $171,000 and $58,000 for performing publishing and distribution
services on behalf of Virgin during the three months ended September 30, 2000
and 1999, respectively, and earned $346,000 and $58,000 for the nine months
ended September 30, 2000 and 1999, respectively.
As of September 30, 2000 and December 31, 1999, Virgin owed the Company
$6.3 million and $9.1 million and the Company owed Virgin $2.2 million and $7.8
million, respectively.
The Company performs distribution services on behalf of Titus in exchange
for a fee or receives. In connection with such distribution services during the
three months ended September 30, 2000 and 1999, the Company recognized zero and
$100,000, respectively, and during the nine months ended September 30, 2000 and
1999, the Company recognized $442,000 and $200,000, respectively.
During the nine months ended September 30, 2000, the Company recognized $3
million in licensing revenue under a multi-product license agreement with Titus
for the technology underlying one title and the content of three titles for
multiple game platforms, for a maximum of twelve years, with variable royalties
payable to the Company from five to ten percent, as defined. The Company earned
a $3 million non-refundable fully-recoupable advance against royalties upon
signing and completing all of its obligations under the agreement. During 1999,
the Company executed publishing agreements with Titus Interactive S.A. ("Titus")
for three titles. As a result of these agreements, the Company recognized
revenue of $0.4 million and $2.6 million for delivery of these titles to Titus
during the three and nine months ended September 30, 1999, respectively.
As of September 30, 2000, Titus owed the Company $0.8 million and the
Company owed Titus $0.7 million. As of December 31, 1999, the Company owed Titus
$0.3 million.
Investment in Affiliate
-----------------------
The Company accounts for its investment in VIE Acquisition Group LLC
("VIE") in accordance with the equity method of accounting. The Company did not
recognize any material income or loss in connection with its investment in VIE
for the three and nine months ended September 30, 2000 and 1999.
11
<PAGE>
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 10. Segment and Geographical Information
The Company operates in one principal business segment. Information about
the Company's operations in the United States and foreign markets is presented
below:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- --------------------
2000 1999 2000 1999
-------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Net revenues:
United States $ 31,456 $ 23,809 $ 73,605 $ 64,888
United Kingdom 175 (173) 223 9,694
-------- -------- -------- --------
Consolidated net revenues $ 31,631 $ 23,636 $ 73,828 $ 74,582
======== ======== ======== ========
Operating income (loss):
United States $ 1,123 $(15,286) $ (4,005) $(24,494)
United Kingdom 14 (822) (514) (3,384)
-------- -------- -------- --------
Consolidated loss from operations $ 1,137 $(16,108) $ (4,519) $(27,878)
======== ======== ======== ========
Expenditures made for the acquisition
of long-lived assets:
United States $ 1,044 $ 77 $ 2,605 $ 986
United Kingdom 15 -- 58 --
-------- -------- -------- --------
Total expenditures for
long-lived assets $ 1,059 $ 77 $ 2,663 $ 986
======== ======== ======== ========
</TABLE>
Net revenues by geographic regions were as follows:
<TABLE>
<CAPTION>
Three Months Ended September 30, Nine Months Ended September 30,
------------------------------------------- -------------------------------------------
2000 1999 2000 1999
------------------- ------------------- ------------------- --------------------
Amount Percent Amount Percent Amount Percent Amount Percent
-------- ------- -------- ------- -------- ------- -------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
North America $19,376 61.3% $10,895 46.1% $41,896 56.7% $35,242 47.4%
Europe 5,925 18.7 4,815 20.4 15,624 21.2 17,846 23.9
Rest of World 2,715 8.6 1,203 5.1 5,154 7.0 4,532 6.1
OEM, royalty and licensing 3,615 11.4 6,723 28.4 11,154 15.1 16,962 22.6
------- ------- ------- ------ ------- ----- ------- -----
$31,631 100.0% $23,636 100.0% $73,828 100.0% $74,582 100.0%
======= ======= ======= ====== ======= ===== ======= =====
</TABLE>
Net investments in long-lived assets by geographic regions were as
follows:
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
------------------ ------------------
Amount Percent Amount Percent
-------- ------- -------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
North America $5,949 97.8% $5,435 97.9%
Europe 75 1.2 47 0.9
Rest of World -- -- -- --
OEM, royalty and licensing 55 1.0 69 1.2
------ ----- ------ -----
$6,079 100.0% $5,551 100.0%
====== ===== ====== =====
</TABLE>
12
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Cautionary Statement
The information contained in this Form 10-Q is intended to update the
information contained in the Company's Annual Report on Form 10-K for the year
ended December 31, 1999 and presumes that readers have access to, and will have
read, the "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and other information contained in such Form 10-K.
This Form 10-Q contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities and Exchange Act of 1934 and such forward-looking statements are
subject to the safe harbors created thereby. For this purpose, any statements
contained in this Form 10-Q, except for historical information, may be deemed to
be forward-looking statements. Without limiting the generality of the foregoing,
words such as "may," "will," "expect," "believe," "anticipate," "intend,"
"could," "estimate" or "continue" or the negative or other variations thereof or
comparable terminology are intended to identify forward-looking statements. In
addition, any statements that refer to expectations, projections or other
characterizations of future events or circumstances are forward-looking
statements.
The forward-looking statements included herein are based on current
expectations that involve a number of risks and uncertainties, as well as on
certain assumptions. For example, any statements regarding future cash flow,
financing activities, cost reduction measures, compliance with the Company's
line of credit and an extension or replacement of such line are forward-looking
statements and there can be no assurance that the Company will generate positive
cash flow in the future or that the Company will be able to obtain financing on
satisfactory terms, if at all, or that any cost reductions effected by the
Company will be sufficient to offset any negative cash flow from operations or
that the Company will remain in compliance with its line of credit or be able to
renew or replace such line. Additional risks and uncertainties include possible
delays in the completion of products, the possible lack of consumer appeal and
acceptance of products released by the Company, fluctuations in demand, lost
sales because of the rescheduling of products launched or orders delivered,
failure of the Company's markets to continue to grow, that the Company's
products will remain accepted within their respective markets, that competitive
conditions within the Company's markets will not change materially or adversely,
that the Company will retain key development and management personnel, that the
Company's forecasts will accurately anticipate market demand, that there will be
no material adverse change in the Company's operations or business. Additional
factors that may affect future operating results are discussed in more detail in
"Factors Affecting Future Performance," below as well as the Company's Annual
Report on Form 10-K on file with the Securities and Exchange Commission.
Assumptions relating to the foregoing involve judgments with respect to, among
other things, future economic, competitive and market conditions, and future
business decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond the control of the Company. Although the
Company believes that the assumptions underlying the forward-looking statements
are reasonable, the business and operations of the Company are subject to
substantial risks that increase the uncertainty inherent in the forward-looking
statements, and the inclusion of such information should not be regarded as a
representation by the Company or any other person that the objectives or plans
of the Company will be achieved. In addition, risks, uncertainties and
assumptions change as events or circumstances change. The Company disclaims any
obligation to publicly release the results of any revisions to these
forward-looking statements which may be made to reflect events or circumstances
occurring subsequent to the filing of this Form 10-Q with the SEC or otherwise
to revise or update any oral or written forward-looking statement that may be
made from time to time by or on behalf of the Company.
13
<PAGE>
Results of Operations
The following table sets forth certain selected consolidated statements
of operations data, segment data and platform data for the periods indicated in
dollars and as a percentage of total net revenues:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------------------- -----------------------------------------
2000 1999 2000 1999
------------------- ------------------- -------------------- -------------------
% of Net % of Net % of Net % of Net
Amount Revenues Amount Revenues Amount Revenues Amount Revenues
-------- -------- -------- -------- -------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net revenues $ 31,631 100.0% $ 23,636 100.0% $ 73,828 100.0% $ 74,582 100.0%
Cost of goods sold 16,195 51.2% 15,333 64.9% 36,350 49.2% 45,441 60.9%
-------- ----- -------- ----- -------- ----- -------- -----
Gross profit 15,436 48.8% 8,303 35.1% 37,478 50.8% 29,141 39.1%
-------- ----- -------- ----- -------- ----- -------- -----
Operating expenses:
Marketing and sales 6,212 19.6% 7,304 30.9% 17,617 23.9% 21,763 29.2%
General and administrative 2,602 8.2% 8,375 35.4% 7,583 10.3% 14,206 19.0%
Product development 5,485 17.3% 5,424 22.9% 16,797 22.8% 16,110 21.6%
Other -- 0.0% 3,308 14.0% -- 0.0% 4,940 6.6%
-------- ----- -------- ----- -------- ----- -------- -----
Total operating expenses 14,299 45.1% 24,411 103.2% 41,997 57.0% 57,019 76.4%
-------- ----- -------- ----- -------- ----- -------- -----
Operating income (loss) 1,137 3.7% (16,108) -68.1% (4,519) -6.2% (27,878) -37.3%
Other expense 1,024 3.2% 857 3.6% 2,757 3.7% 2,920 3.9%
-------- ----- -------- ----- -------- ----- -------- -----
Income (loss) before income taxes 113 0.5% (16,965) -71.7% (7,276) -9.9% (30,798) -41.2%
Provision for income taxes -- 0.0% 11 0.0% -- 0.0% 1,384 1.9%
-------- ----- -------- ----- -------- ----- -------- -----
Net income (loss) $ 113 0.5% $(16,976) -71.7% $ (7,276) -9.9% $(32,182) -43.1%
======== ===== ======== ===== ======== ===== ======== =====
Net revenues by geographic region:
North America $ 19,376 61.3% $ 10,895 46.1% $ 41,896 56.7% $ 35,242 47.4%
International 8,640 27.3% 6,018 25.5% 20,778 28.2% 22,378 30.0%
OEM, royalty and licensing 3,615 11.4% 6,723 28.4% 11,154 15.1% 16,962 22.6%
Net revenues by platform:
Personal computer $ 23,814 75.3% $ 13,192 55.9% $ 51,393 69.6% $ 46,096 61.9%
Video game console 4,202 13.3% 3,721 15.7% 11,281 15.3% 11,524 15.5%
OEM, royalty and licensing 3,615 11.4% 6,723 28.4% 11,154 15.1% 16,962 22.6%
</TABLE>
North American, International and OEM, Royalty and Licensing Net Revenues
-------------------------------------------------------------------------
Overall, net revenues for the three months ended September 30, 2000
increased 34 percent compared to the same period in 1999. The increase in North
American net revenues for the three months ended September 30, 2000 was
primarily due to the release of Baldur's Gate II on PC, the sequel to the major
hit title Baldur's Gate. The increase in international net revenues was due
primarily to the release of the English version of Baldur's Gate II. The Company
expects to release foreign language versions of Baldur's Gate II in the fourth
quarter of 2000. OEM, royalty and licensing net revenues decreased in the three
months ended September 30, 2000 compared to the same period in 1999 due to
decreased net revenues in licensing transactions and the OEM business. Licensing
revenues decreased 83 percent primarily due to the recognition of $2.2 million
in deferred revenue for the shipment of a title to a customer in 1999 without a
comparable transaction of this size in 2000. The OEM business decreased 13
percent primarily due to a $1 million single transaction with a customer in 1999
without a comparable transaction of this size in 2000.
Total net revenues for the nine months ended September 30, 2000 were
generally consistent with the same period in 1999. The increase in North
American net revenues for the nine months ended September 30, 2000 was primarily
due to the release of two major new titles - Baldur's Gate II and Icewind Dale
without comparable major new titles being released in 1999. The Company had
fewer title releases across multiple platforms this year as compared to last
year, but this years titles generally had higher sales volume. This results from
the Company's efforts of a more focused product planning and release schedule of
less, but higher quality titles. In addition, the Company experienced a lower
level of product returns and allowances compared to the same period in 1999. The
Company expects that future North American net revenues in 2000 will increase
slightly compared to 1999. The decrease in international net revenues was due
primarily to decreased net revenues in Europe, due to strong sales of the major
hit title Baldur's Gate in the 1999 period that did not repeat in 2000 and only
releasing the English version
14
<PAGE>
of Baldur's Gate II in the 2000 period, offset in part by a lower level of
product returns and allowances compared to the same period in 1999. The foreign
language versions of Baldur's Gate II are expected to be released in the
respective European territories during the fourth quarter of 2000. The Company
expects that international net revenues in 2000 will increase slightly compared
to 1999. OEM, royalty and licensing net revenues decreased in the nine months
ended September 30, 2000 compared to the same period in 1999 due to decreased
net revenues from the OEM business and licensing transactions. The decrease in
the OEM business is primarily due to a decrease in the volume of transactions
and the decrease in licensing transactions is primarily due to the recognition
of deferred revenue for the shipment of a title to a customer in 1999 without a
comparable transaction in 2000. The Company expects that future OEM, royalty and
licensing net revenues in 2000 will be lower as compared to 1999.
Platform Net Revenues
---------------------
PC net revenues increased in the three months ended September 30, 2000
compared to the same period in 1999 primarily due to the release of Baldur's
Gate II. In addition, the provision for returns and allowances decreased from 16
percent of gross revenues for the three months ended September 30, 1999 to 12
percent of gross revenues in the 2000 period due to the Company's significantly
improved inventory in channel position and continued concentration on a sell-
through product distribution strategy. The Company released four PC titles
during the three months ended September 30, 2000 compared to nine PC titles in
the 1999 period. Video game console net revenues were generally consistent in
the three months ended September 30, 2000 compared to the same period in 1999.
The Company released one console title compared to two titles in the 1999
period.
Net revenues of PC titles increased in the nine months ended September 30,
2000 compared to the same period in 1999 primarily due to the release of
Baldur's Gate II and Icewind Dale. In addition, the provision for returns and
allowances decreased from 21 percent of gross revenues for the nine months ended
September 30, 1999 to 14 percent of gross revenues in the 2000 period due to the
Company's significantly improved inventory-in-channel position and continued
concentration on a sell-through product distribution strategy. The Company
expects its PC net revenues to increase in total for 2000 compared to 1999.
Video game console net revenues were generally consistent in the nine months
ended September 30, 2000 compared to the same period in 1999 due to higher unit
sales offset by lower price points for current generation console titles. The
Company expects its future video game console net revenues to slightly increase
in total in 2000 as a result of the added penetration into this segment and the
release of two titles in the fourth quarter of 2000 compared to one in the same
period of 1999.
Cost of Goods Sold; Gross Profit Margin
---------------------------------------
Cost of goods sold increased in the three months ended September 30, 2000
compared to the same period in 1999 due to higher net revenues, offset partially
by a higher percentage of internally developed titles. The increase in gross
profit margin was primarily due to a higher percentage of internally developed
titles sold and a lower level of product returns.
Cost of goods sold decreased in the nine months ended September 30, 2000
compared to the same period in 1999 due to higher net revenues, offset
partially by a higher percentage of internally developed titles. The 1999 period
also reflects write-offs of prepaid royalties in 1999 relating to titles which
had been canceled mainly due to the Company discontinuing its licensed sports
product line last year. The Company expects its future cost of goods sold to
decrease in 2000 as compared to 1999 due to a higher percentage of internally
developed titles and a lack of significant write-offs of prepaid royalties. The
increase in gross profit margin was primarily due to a higher percentage of
internally developed titles sold and a lower level of product returns and
markdowns compared to the 1999 period. The Company expects its future gross
profit margin to increase in total for 2000 as compared to 1999 due to a
significantly improved inventory in channel position and continued concentration
on a sell-through product distribution strategy, offset in part by an increase
in video game console releases with a higher cost of goods relative to net
revenues.
Marketing and Sales
-------------------
Marketing and sales expenses primarily consist of advertising and retail
marketing support, sales commissions, marketing and sales personnel, customer
support services and other related operating expenses. The decreases in
marketing and sales expenses for the three and nine months ended September 30,
2000 compared to the 1999 periods are attributable primarily to decreased
advertising and retail marketing support expenditures as well as, in the current
nine month period, to lower personnel costs. In addition, the Company amended
its International Distribution Agreement with Virgin Interactive Entertainment
Limited ("Virgin") effective January 1, 2000, which eliminated the fixed monthly
overhead fees the Company incurred in the 1999 period. Due on part to this
amendment, the Company expects its
15
<PAGE>
marketing and sales expenses to continue to decrease in total for 2000 as
compared to 1999. However, Virgin has disputed the validity of this amendment,
and believes that the Company remains obligated to pay the monthly overhead and
minimum commission charges as provided by the original agreement. See "Factors
Affecting Future Performance -- Distribution Agreement".
General and Administrative
--------------------------
General and administrative expenses primarily consist of administrative
personnel expenses, facilities costs, professional fees, bad debt expenses and
other related operating expenses. The decrease in general and administrative
expenses for the three and nine months ended September 30, 2000 is primarily
attributable to a decrease in bad debt expense. The Company is continuing its
efforts to reduce North American operating expenses and expects its general and
administrative expenses to continue to decrease in total for 2000 as compared to
1999.
Product Development
-------------------
Product development expenses, which primarily consist of personnel and
support costs, are charged to operations in the period incurred. The increase in
product development expenses for the three and nine months ended September 30,
2000 is primarily due to increased expenditures devoted to the Company's focus
on next generation video game console platforms. The Company expects its product
development expenses to continue to increase in total for 2000 as compared to
1999.
Other Operating Expense
-----------------------
Other operating expenses are primarily one-time expenses associated
with the operations of the Company. During the three and nine months ended
September 30, 2000 the Company did not incur any other operating expenses. Other
operating expenses of $3.3 million and $4.9 million for the three and nine
months ended September 30, 1999, respectively, were due primarily to the
anticipated asset valuation and restructuring charge in connection with the
Company's reductions in its European operations. Included in these amounts was a
$2.7 million provision to cover certain minimum operating charges payable to
Virgin which did not repeat in 2000. In addition, the Company recorded severance
expense for the departure of the Company's former president during the nine
months ended September 30, 1999.
Other Expense, net
------------------
Other expense consists primarily of interest expense on the Company's line
of credit and foreign currency exchange transaction losses. Other expense
increased in the three months ended September 30, 2000 compared to the same
period in 1999 due to higher foreign currency exchange transaction losses
incurred in connection with European distribution, which were offset partially
by decreased interest expense on lower average borrowings under the Company's
line of credit. The decrease in the nine months ended September 30, 2000
compared to the same period in 1999 was due to decreased interest expense on
lower average borrowings under the Company's line of credit which was offset
partially by foreign currency exchange transaction losses incurred in connection
with European distribution.
Liquidity and Capital Resources
The Company has funded its operations to date primarily through the use of
lines of credit and equipment leases, through cash generated by the private sale
of securities, from the proceeds of its initial public offering and from
operations.
As of September 30, 2000 the Company's principal sources of capital
included cash of $0.6 million, $4.9 million available under the Company's
financial institution line of credit expiring in April 2001 and $5 million
available under the Company's supplemental line of credit with Titus expiring in
May 2001. The Company has been notified by Titus, our principal stockholder,
that they believe that they are no longer obligated to fund the $5 million line
of credit they extended in April 2000. The Company's outstanding borrowings on
the financial institution line of credit was $16.2 million with no stand by
letters of credit outstanding at September 30, 2000. As of September 30, 2000,
the Company's availability under its financial institution line of credit was
$5.5 million. The line of credit bears interest at the London Interbank Offered
Rate plus 4.87 percent (11.49 percent as of September 30, 2000). Under the terms
of the line of credit, the Company has maximum availability for borrowings and
letters
16
<PAGE>
of credit up to $25 million based in part upon qualifying receivables and
inventory. Within the overall credit limit, the line of credit also provides
that the Company may borrow up to $7 million in excess of its borrowing base.
Under the line of credit the Company is required to maintain a $5 million
personal guarantee by the Company's Chairman and Chief Executive Officer
("Chairman") and a $20 million corporate guarantee provided by Titus. In
connection with the $20 million corporate guarantee provided by Titus, if the
Company defaults under the terms of the line of credit agreement, and the
financial institution demands Titus to pay on its corporate guarantee, Titus may
have the right to receive additional shares of the Company's Common Stock upon
conversion of their Preferred Stock, as discussed in more detail below.
Based upon certain assumptions, including without limitation, the Company's
ability to achieve anticipated operating results, the Company believes that it
will be able to replace its line of credit or obtain alternative financing on
reasonable terms. However, there can be no assurance that the assumptions relied
on by the Company will prove correct or that the Company will be able to renew
or replace its line of credit or obtain alternative financing on reasonable
terms, if at all. If the Company is unable to replace its line of credit, such
failure would have significant adverse effects on the Company, as discussed
below.
The Company's primary capital needs have historically been to fund working
capital requirements necessitated by its net losses, its sales growth and
fluctuation, the development and introduction of products and related
technologies and the acquisition or lease of equipment and other assets used in
the product development process. The Company's operating activities used cash of
$16.6 million during the nine months ended September 30, 2000, primarily
attributable to a decrease in accounts payable and accrued liabilities, an
increase in accounts receivable and the net loss for the nine month period then
ended, offset in part by an increase in inventories and depreciation and
amortization. Cash provided by financing activities of $19.5 million for the
nine months ended September 30, 2000 consisted primarily of the proceeds from
the issuance of the Company's Series A Preferred Stock ("Preferred Stock") to
Titus and the release of restricted cash by the Company's financial institution,
offset in part by reductions to the outstanding balance under the Company's line
of credit. Cash used in investing activities of $2.7 million for the nine months
ended September 30, 2000 consisted of capital expenditures, primarily for office
and computer equipment used in Company operations. The Company does not
currently have any material commitments with respect to any capital
expenditures.
To reduce the Company's working capital needs, the Company has implemented
various measures including a reduction of personnel, a reduction of fixed
overhead commitments and has scaled back certain marketing programs. In
addition, the Company believes that its amended International Distribution
Agreement with Virgin will further reduce its international costs and expenses
in future periods. However, Virgin has disputed the validity of this amendment,
and believes that the Company remains obligated to pay the monthly overhead and
minimum commission charges as provided by the original agreement. See "Factors
Affecting Future Performance - Distribution Agreement". The Company is pursuing
various alternatives, including further expense reductions, in an effort to
continue to reduce operating expenses as much as possible without an adverse
impact on its ability to generate successful future business activities. There
can be no assurance that the Company will be able to undertake such measures, or
that such measures would not materially and adversely affect the Company's
ability to publish commercially viable titles, or that such measures would be
sufficient to generate operating profits. In addition, the Company's long term
liquidity will be materially dependent on its ability to develop and market
successful titles for the hardware platforms that dominate the interactive
entertainment market.
To provide working capital to support the Company's future operations, the
Company took several actions including extending its line of credit to April
2001, as discussed above. In addition, the Company completed a transaction with
Titus under a Stock Purchase Agreement dated April 14, 2000 and issued 719,424
shares of newly designated Preferred Stock which has preferences under certain
events, as defined. The Preferred Stock is convertible by Titus, redeemable by
the Company, and accrues a 6 percent dividend per annum. The Company may redeem
the Preferred Stock at the original issue price at any time after termination of
Titus's guarantee of the Company's principal line of credit. Titus may convert
the Preferred Stock shares into shares of Common Stock at any time after May
2001 or earlier under certain events as defined. The conversion rate is the
lesser of $2.78 (7,194,240 shares of Common Stock) or 85 percent of the market
price per share at the time of conversion, as defined. The Preferred Stock is
entitled to the same voting rights as if it had been converted to Common Stock
subject to a maximum of 7,619,047 votes. In the event that the Company defaults
on its line of credit and Titus is forced to pay on its corporate guarantee of
such line, the Series A Preferred Stock conversion rights will be adjusted so as
to make such shares convertible into up to approximately 42.8 million shares of
Common Stock. In the event that the Company is able to repay to Titus the
amounts paid under the guarantee within six months, the conversion rate shall be
returned to the level at which it existed prior to such adjustment. In the event
that the Company is unable to repay such amounts within six months, the
conversion rate shall be readjusted at the end of such nine month period based
on the average closing price of the Company's Common Stock for the last 20
trading days
17
<PAGE>
during such period. If such average price is $10.00 per share, the shares would
be convertible into 7,194,240 shares of Common Stock, and if less than $10.00,
the shares would be convertible into approximately an additional 5,000,000
shares for each dollar the average price is below $10.00, up to a maximum of
approximately 42.8 million shares.
In connection with this transaction, Titus received a warrant for 350,000
shares of Common Stock at $3.79 per share exercisable at any time, and a warrant
for 50,000 shares of the Company's Common Stock at $3.79 per share which would
only be exercisable by Titus if the Company's audited pre-tax income for the
year ending December 31, 2000, is less than $2.1 million. Both warrants expire
in April 2010. The Common Stock shares issuable upon conversion of the Preferred
Stock or the exercise of the warrants are subject to certain registration
rights. The Company also obtained a $5 million supplemental secured line of
credit with Titus expiring in May 2001. The Company has been notified by Titus,
our principal stockholder, that they believe that they are no longer obligated
to fund the $5 million line of credit they extended in April 2000. Amounts drawn
on this line will be subject to interest at the maximum legal rate for parties
other than financial institutions, currently 10 percent per annum, payable
quarterly. In connection with this line of credit, Titus received a warrant for
up to 100,000 shares of the Company's Common Stock at $3.79 per share that will
expire in April 2010. The warrant will become exercisable if and to the extent
that the Company borrows under the line of credit. No amounts have been borrowed
under this line of credit.
The Company believes that funds available under its lines of credit,
amounts to be received from equity financing, amounts to be received under
various product license and distribution agreements and anticipated funds from
operations will be sufficient to satisfy the Company's projected working capital
and capital expenditure needs in the normal course of business at least through
the expiration of its line of credit in April 2001. Based upon certain
assumptions, including without limitation, the Company's ability to achieve
anticipated operating results, the Company believes that it will be able to
replace its line of credit or obtain alternative financing on reasonable terms.
However, there can be no assurance that the assumptions relied on by the Company
will prove correct or that the Company will be able to replace its line of
credit on satisfactory terms, if at all. The Company's failure to replace its
line of credit would have significant adverse effects on the Company, as
discussed above. Further, there can be no assurance that the Company will not be
required to raise additional working capital through debt or equity financing
during such period. If the Company is required to raise additional working
capital, there can be no assurance that the Company will be able to raise such
additional working capital on acceptable terms, if at all. In the event the
Company is unable to raise additional working capital, further measures would be
necessary including, without limitation, the sale or consolidation of certain
operations, the delay, cancellation or scale back of product development and
marketing programs and other actions. No assurance can be given that such
measures would not materially adversely affect the Company's ability to develop
and publish commercially viable titles, or that such measures would be
sufficient to generate operating profits in 2000 and beyond. Certain of such
measures may require third party consents or approvals, including the Company's
financial institution, and there can be no such assurance that such consents or
approvals can be obtained.
The Company's consolidated financial statements have been presented on the
basis that it is a going concern. However, the Company's independent public
accountant has informed the Company that if the Company is unable to replace
its lines of credit with its current financial institution or alternative
sources and Titus or obtain alternative debt or equity financing sufficient to
cover its operating cash flow requirements through December 31, 2001 and beyond,
that it is likely that it will render a modified report for going concern on the
Company's financial statements as of December 31, 2000.
FACTORS AFFECTING FUTURE PERFORMANCE
Our future operating results depend upon many factors and are subject to
various risks and uncertainties. Some of the risks and uncertainties which may
cause our operating results to vary from anticipated results or which may
materially and adversely affect its operating results are as follows:
Liquidity; Future Capital Requirements
We used net cash in operations of $16.6 million and $26.4 million during
the nine months ended September 30, 2000 and the year ended December 31, 1999,
respectively. At September 30, 2000, our working capital was $5 million. We
cannot assure you that we will ever generate positive cash flow from operations.
Our ability to fund our capital requirements out of our available cash, lines of
credit and cash generated from our operations depends on a number of factors.
Some of these factors include the progress of our product development programs,
the rate of growth of our business, and our products' commercial success. Our
principal line of credit expires in April 2001, and we cannot assure you that
our lender will renew that line of credit. We have been notified by Titus
Interactive SA ("Titus"), our principal stockholder, that they believe they are
no longer obligated to fund the $5 million line of credit they extended to us in
April 2000. Under the circumstances, we will likely have to seek additional
funds through debt or equity financings, product licensing or distribution
transactions or other sources of financing in order to provide ourselves with
enough working capital. If we issue additional equity securities, our existing
stockholders could suffer a large amount of dilution in their ownership. In the
event we have to raise additional working capital from other sources, we cannot
assure you that we will be able to raise additional working capital on
acceptable terms, if at all. In the event we cannot raise additional working
capital, we would have to take additional
18
<PAGE>
actions to continue to reduce our costs, including selling or consolidating
certain operations, delaying, canceling or scaling back product development and
marketing programs and other actions. These measures could materially and
adversely affect our ability to publish successful titles, and these measures
may not be enough to generate operating profits. We might have to get the
approval of other parties, including our financial lender and/or Titus, for some
of these measures, and we cannot assure you that we would be able to obtain
those approvals. In addition, there is a risk that our Common Stock may be
delisted from the Nasdaq National Market (see "Continued Listing on the Nasdaq
National Market," below). If such delisting were to occur, our ability to raise
equity capital could be significantly impaired.
Fluctuations in Operating Results; Uncertainty of Future Results; Seasonality
Our operating results have fluctuated a great deal in the past and will
probably continue to fluctuate significantly in the future, both on a quarterly
and an annual basis. Many factors may cause or contribute to these fluctuations,
and many of these factors are beyond our control. Some of these factors include
the following:
. delays in shipping our products
. demand for our products
. demand for our competitors' products
. the size and rate of growth of the market for interactive entertainment
software
. changes in PC and video game console platforms
. the number of new products and product enhancements released by us and
our competitors
. changes in our product mix
. the number of our products that are returned
. the timing of orders placed by our distributors and dealers
. the timing of our development and marketing expenditures
. price competition
. the level of our international and OEM, royalty and licensing net
revenues.
Many factors make it difficult to accurately predict the quarter in which
we will ship our products. Some of these factors include:
. the uncertainties associated with the interactive entertainment software
development process
. long manufacturing lead times for Nintendo-compatible products
. possible production delays
. the approval process for products compatible with the Sony Computer
Entertainment, Nintendo and Sega video game consoles
. approvals required from other licensors
. the timing of the release and market penetration of new game hardware
platforms.
Because of the limited number of products we introduce in any particular
quarter, a delay in the introduction of a product may materially and adversely
affect our operating results for that quarter, and may not be recaptured in
later quarters. Such delays have had a significant adverse effect on our
operating results in certain past quarters. A significant portion of our
operating expenses is relatively fixed, and planned expenditures are based
largely on sales forecasts. If net revenues do not meet our expectations in any
given quarter, operating results may be materially adversely affected. The
interactive entertainment software industry is highly seasonal, with the highest
levels of consumer demand occurring during the year-end holiday buying season.
As a result, our net revenues, gross profits and operating income have
historically been highest during the second half of the year. Revenues are also
materially affected by new product releases. Our failure or inability to
introduce products on a timely basis to meet these seasonal increases in demand
may have a material adverse effect on our business, operating results and
financial condition.
We may over time become increasingly affected by the industry's seasonal
patterns. Although we seek to reduce the effect of such seasonal patterns on our
business by distributing our product release dates more evenly throughout the
year, we cannot assure you that these efforts will be successful. We cannot
assure you that we will be profitable in any particular period given the
uncertainties associated with software development, manufacturing, distribution
and the impact of the industry's seasonal patterns on our net revenues.
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As a result of the foregoing factors it is likely that our operating
results in one or more future periods will fail to meet or exceed the
expectations of securities analysts or investors. In that event, the trading
price of our Common Stock would likely be materially adversely affected.
Significant Recent Losses
We have experienced significant net losses in recent periods, including
losses of $7.3 million and $41.7 million for the nine months ended September 30,
2000 and the year ended December 31, 1999, respectively. These losses resulted
largely from delays in the completion of certain products, a higher than
expected level of product returns and markdowns on products released during the
year, and the cost of restructuring our operations, including international
distribution arrangements. These losses also resulted from lower than expected
worldwide sales of certain releases, as well as from operating expense levels
that were high relative to our revenue level. We may experience similar problems
in current or future periods and we may not be able to generate sufficient net
revenues or adequate working capital, or bring our costs into line with
revenues, so as to attain or sustain profitability in the future.
Dependence on New Product Introductions; Risk of Product Delays and Product
Defects
Our products typically have short life cycles, and we depend on the timely
introduction of successful new products to generate net revenues, to fund
operations and to replace declining net revenues from older products. These new
products include enhancements of or sequels to our existing products and
conversions of previously released products to additional platforms. If in the
future, for any reason, net revenues from new products fail to replace declining
net revenues from existing products, our business, operating results and
financial condition could be materially adversely affected. The timing and
success of new interactive entertainment software product releases remains
unpredictable due to the complexity of product development, including the
uncertainty associated with new technology. The development cycle of new
products is difficult to predict but typically ranges from 12 to 24 months with
six to 12 months for adapting a product to a different technology platform. The
success of any particular software product can also be negatively impacted by
delays in the introduction, manufacture or distribution of the platform for
which the product was developed (see "Rapidly Changing Technology; Platform
Risks"). In the past, we have frequently experienced significant delays in the
introduction of new products, including certain products currently under
development. Because net revenues associated with the initial shipments of a new
product generally constitute a high percentage of the total net revenues
associated with a product, any delay in the introduction of, or the presence of
a defect in, one or more new products expected in a period could have a material
adverse effect on the ultimate success of these products and on our business,
operating results and financial condition. The cost of developing and marketing
new interactive entertainment software has increased in recent years due to such
factors as the increasing complexity and content of interactive entertainment
software, the increasing sophistication of hardware technology and consumer
tastes and the increasing costs of obtaining licenses for intellectual
properties. We expect this trend to continue. We cannot assure you that our new
products will be introduced on schedule, if at all, or that, if introduced,
these products will achieve significant market acceptance or generate
significant net revenues for us. In addition, software products as complex as
the ones we offer may contain undetected errors when first introduced or when
new versions are released. We cannot assure you that, despite testing prior to
release, errors will not be found in new products or releases after shipment,
resulting in loss of or delay in market acceptance. This loss or delay could
have a material adverse effect on our business, operating results and financial
condition.
Uncertainty of Market Acceptance; Dependence on Hit Titles
Consumer preferences for interactive entertainment software are always
changing and are extremely difficult to predict. Historically, few interactive
entertainment software products have achieved continued market acceptance.
Instead, a limited number of releases have become "hits" and have accounted for
a substantial portion of revenues in our industry. Further, publishers with a
history of producing hit titles have enjoyed a significant marketing advantage
because of their heightened brand recognition and consumer loyalty. We expect
the importance of introducing hit titles to increase in the future. We cannot
assure you that our new products will achieve significant market acceptance, or
that we will be able to sustain this acceptance for a significant length of time
if we achieve it. We also cannot assure you that product life cycles will be
sufficient to permit us to recover product development and other associated
costs. Most of our products have a relatively short life cycle and sell for a
limited period of time after their initial release, usually less than one year.
We believe that these trends will continue in our industry
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and that our future revenue will continue to be dependent on the successful
production of hit titles on a continuous basis. Because we introduce a
relatively limited number of new products in a given period, the failure of one
or more of these products to achieve market acceptance could have a material
adverse effect on our business, operating results and financial condition.
Further, if we do not achieve market acceptance, we could be forced to accept
substantial product returns or grant significant markdown allowances to maintain
our relationship with retailers and our access to distribution channels. For
example, we had significantly higher than expected product returns and markdowns
during the year ended December 31, 1999 and we cannot assure you that higher
than expected product returns and markdowns will not continue in the future. In
the event that we are forced to accept significant product returns or grant
significant markdown allowances, our business, operating results and financial
condition could be materially adversely affected.
Control by Titus
Titus currently owns 12,817,255 shares, or approximately 43 percent, of our
outstanding Common Stock, and 719,424 shares of our Series A Preferred Stock
that have voting power equivalent to up to 7,619,047 shares of Common Stock, and
are convertible into at least 7,194,240 shares of Common Stock at any time after
May 2001 if not previously redeemed by the Company. Titus also holds warrants
for up to 500,000 shares of our Common Stock. In addition, if we default on our
line of credit and Titus is obligated to pay on their $20 million corporate
guarantee of our line of credit, the Series A Preferred Stock could become
convertible into, and have voting rights equal to, up to 42.8 million shares of
our Common Stock, which would constitute approximately 75 percent of our Common
Stock as of the date hereof. In connection with Titus' investment, Herve Caen,
Titus' chairman and chief executive officer, serves as our president and as a
member of our Board of Directors, and Herve Caen's brother Eric Caen, who is
president and a director of Titus, also serves on our Board of Directors. As a
consequence, Titus holds significant voting power with respect to the election
of our Board of Directors and the right of approval of certain significant
corporate actions, and Herve Caen and Eric Caen have substantial authority over
our operations. As the Company's capital structure currently stands, in the
event that the Stockholder Agreement pursuant to which our Board of Directors is
currently nominated terminates, Titus would be able to elect 4 of 7 members of
the Board of Directors. In such event, Titus would be able to set our dividend
policy and otherwise exercise substantial control over our management. This
control could prevent or hinder a sale of the Company on terms that are not
acceptable to Titus. Moreover, Titus holds interests that may vary from those of
the Company and its other stockholders, and Titus may exercise its control of
the Company in the furtherance of such outside interests (see the subsections
entitled "Liquidity; Future Capital Requirements", "Distribution Agreement" and
"Risks Associated with Acquisitions").
Continued Listing on the NASDAQ National Market
Our Common Stock is currently quoted on the Nasdaq National Market under
the symbol "IPLY." For continued inclusion on the Nasdaq National Market, a
company must meet certain tests, including a minimum bid price of $1.00 and net
tangible assets of at least $4 million. As of December 31, 1999, we were not in
compliance with the minimum net tangible assets requirement, and did not return
to compliance with that requirement until April 14, 2000. If we fail to satisfy
the listing standards on a continuous basis, our Common Stock may be removed
from listing on the Nasdaq National Market. If our Common Stock were delisted
from the Nasdaq National Market, trading of our Common Stock, if any, would be
conducted on the Nasdaq Small Cap Market, in the over-the-counter market on the
so-called "pink sheets" or, if available, the NASD's "Electronic Bulletin
Board." In any of those cases, investors could find it more difficult to buy or
sell, or to obtain accurate quotations as to the value of, our Common Stock. The
trading price per share of our Common Stock would most likely be reduced as a
result.
Distribution Agreement
In connection with our acquisition of a 43.9 percent membership interest in
Virgin Interactive Entertainment Limited's ("Virgin") parent entity in February
1999, we signed an International Distribution Agreement with Virgin. Under this
Agreement, we appointed Virgin as our exclusive distributor for substantially
all of our products in Europe, the CIS, Africa and the Middle East, subject to
certain reserved rights, for a seven-year period. We pay Virgin a distribution
fee for marketing and distributing our products, as well as certain direct costs
and expenses. Virgin has been inconsistent in meeting its obligations to deliver
to us the proceeds obtained from their distribution of our products. Because of
the exclusive nature of the Agreement, if Virgin were to continue to be
inconsistent in meeting its obligations to deliver to us proceeds from
distribution, or were to experience problems with its business,
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or otherwise to fail to perform under the Agreement, our business, operating
results and financial condition could be materially and adversely affected.
Virgin is in the process of recapitalizing its business. In September 2000,
Titus advanced certain amounts to Virgin in anticipation of converting this
advance into equity in Virgin's parent entity. Titus and the Company are
negotiating the terms of such a conversion whereby it is anticipated that the
Company's 43.9% membership interest in Virgin's parent entity would be reduced.
Virgin has disputed an amendment to the International Distribution
Agreement with the Company, and claims that the Company is obligated, among
other things, to pay a contribution to their overhead of up to approximately
$9.3 million annually, subject to decrease by the amount of commissions earned
by Virgin on its distribution of our products. We believe that the amendment is
legally binding and we will vigorously defend our position. However, we cannot
assure you that we will be successful in our defense.
Virgin has earned approximately $2.5 million in commissions through
September 30, 2000, and our forecasts indicate that Virgin may earn $2.0 million
in additional commissions for the period of July 1, 2000, through December 31,
2000. If we are unable to successfully defend our position against Virgin's
claims, we estimate that our maximum exposure would be $4.8 million.
Dependence on Third Party Software Developers
We rely on third party interactive entertainment software developers for
the development of a significant number of our interactive entertainment
software products. As there continues to be high demand for reputable and
competent third party developers, we cannot assure you that third party software
developers that have developed products for us in the past will continue to be
available to develop products for us in the future. Many third party software
developers have limited financial resources, which could expose us to the risk
that such developers may go out of business prior to completing a project. In
addition, due to our limited control over third party software developers, we
cannot assure you that such developers will complete products for us on a timely
basis or within acceptable quality standards, if at all. Due to increased
competition for skilled third party software developers, we have had to agree to
make advance payments on royalties and guaranteed minimum royalty payments to
intellectual property licensors and game developers, and we expect to continue
to enter into these kinds of arrangements. If the products subject to these
arrangements do not have sufficient sales volumes to recover these royalty
advances and guaranteed payments, we would have to write-off unrecovered
portions of these payments, which could have a material adverse effect on our
business, operating results and financial condition. Further, we cannot assure
you that third party developers will not demand renegotiation of their
arrangements with the Company.
Rapidly Changing Technology; Platform Risks
The interactive entertainment software industry is subject to rapid
technological change. New technologies, including operating systems such as
Microsoft Windows 98 and 2000, technologies that support multi-player games, new
media formats such as on-line delivery and digital video disks ("DVDs") and
planned releases in the near future of new video game platforms such as the Sony
Playstation 2, the Nintendo Gamecube and the Microsoft X-Box could render our
current products or products in development obsolete or unmarketable. We must
continually anticipate and assess the emergence of, and market acceptance of,
new interactive entertainment software platforms well in advance of the time the
platform is introduced to consumers. Because product development cycles are
difficult to predict, we must make substantial product development and other
investments in a particular platform well in advance of introduction of the
platform. If the platforms for which we develop software are not released on a
timely basis or do not attain significant market penetration, our business,
operating results and financial condition could be materially adversely
affected. Alternatively, if we fail to develop products for a platform that does
achieve significant market penetration, then our business, operating results and
financial condition could also be materially adversely affected.
The emergence of new interactive entertainment software platforms and
technologies and the increased popularity of new products and technologies may
materially and adversely affect the demand for products based on older
technologies. The broad range of competing and incompatible emerging
technologies may lead consumers to postpone buying decisions with respect to
products until one or more emerging technologies gain widespread acceptance.
This postponement could have a material adverse effect on our business,
operating results and financial
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condition. We are currently developing products for Microsoft Windows 98 and
2000, and Sony PlayStation 2. We are also planning to develop product for new
platforms expected to be introduced in 2001 by Microsoft and Nintendo. Our
success will depend in part on our ability to anticipate technological changes
and to adapt our products to emerging game platforms. We cannot assure you that
we will be able to anticipate future technological changes, to obtain licenses
to develop products for those platforms on favorable terms or to create software
for those new platforms. Any failure to do so could have a material adverse
effect on our business, operating results and financial condition.
Industry Competition; Competition for Shelf Space
The interactive entertainment software industry is intensely competitive
and new interactive entertainment software programs and software platforms are
regularly introduced. Our competitors vary in size from small companies to very
large corporations with significantly greater financial, marketing and product
development resources than ours do. Due to these greater resources, certain of
our competitors can undertake more extensive marketing campaigns, adopt more
aggressive pricing policies, pay higher fees to licensors of desirable motion
picture, television, sports and character properties and pay more to third party
software developers than we can. We believe that the main competitive factors in
the interactive entertainment software industry include:
. product features
. brand name recognition
. access to distribution channels
. quality
. ease of use, price, marketing support and quality of customer service.
We compete primarily with other publishers of PC and video game console
interactive entertainment software. Significant competitors include:
. Electronic Arts Inc.
. Activision, Inc.
. Infogrames Entertainment
. Microsoft Corporation
. LucasArts Entertainment Company
. Midway Games Inc.
. Acclaim Entertainment, Inc.
. Havas Interactive
. Hasbro, Inc.
. The 3DO Company
. Take Two Interactive Software, Inc.
. Eidos PLC
. THQ Inc.
In addition, integrated video game console hardware/software companies such
as Sony Computer Entertainment, Nintendo and Sega compete directly with us in
the development of software titles for their respective platforms. Large
diversified entertainment companies, such as The Walt Disney Company, many of
which own substantial libraries of available content and have substantially
greater financial resources, may decide to compete directly with us or to enter
into exclusive relationships with our competitors. We also believe that the
overall growth in the use of the Internet and on-line services by consumers may
pose a competitive threat if customers and potential customers spend less of
their available home PC time using interactive entertainment software and more
using the Internet and on-line services.
Retailers of our products typically have a limited amount of shelf space
and promotional resources, and there is intense competition among consumer
software producers, and in particular interactive entertainment software
products, for high quality retail shelf space and promotional support from
retailers. To the extent that the number of consumer software products and
computer platforms increases, competition for shelf space may intensify and may
require us to increase our marketing expenditures. Due to increased competition
for limited shelf space, retailers and distributors are in an increasingly
better position to negotiate favorable terms of sale, including price discounts,
price protection, marketing and display fees and product return policies. Our
products constitute a relatively small
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percentage of any retailer's sale volume, and we cannot assure you that
retailers will continue to purchase our products or to provide our products with
adequate levels of shelf space and promotional support. A prolonged failure in
this regard may have a material adverse effect on our business, operating
results and financial condition.
Dependence on Distribution Channels; Risk of Customer Business Failures; Product
Returns
We currently sell our products directly through our own sales force to mass
merchants, warehouse club stores, large computer and software specialty chains
through catalogs in the U.S. and Canada, as well as to certain distributors.
Outside North America, we generally sell products to third party distributors.
Our sales are made primarily on a purchase order basis, without long-term
agreements. The loss of, or significant reduction in sales to, any of our
principal retail customers or distributors could materially adversely affect our
business, operating results and financial condition.
The distribution channels through which publishers sell consumer software
products evolve continuously through a variety of means, including
consolidation, financial difficulties of certain distributors and retailers, and
the emergence of new distributors and new retailers such as warehouse chains,
mass merchants and computer superstores. As more consumers own PCs, the
distribution channels for interactive entertainment software will likely
continue to change. Mass merchants have become the most important distribution
channels for retail sales of interactive entertainment software. A number of
these mass merchants have entered into exclusive buying arrangements with other
software developers or distributors, which arrangements could prevent us from
selling certain of our products directly to that mass merchant. If the number of
mass merchants entering into exclusive buying arrangements with our competitors
were to increase, our ability to sell to such merchants would be restricted to
selling through the exclusive distributor. Because sales to distributors
typically have a lower gross profit than sales to retailers, this would have the
effect of lowering our gross profit. This trend could have a material adverse
impact on our business, operating results and financial condition. In addition,
emerging methods of distribution, such as the Internet and on-line services, may
become more important in the future, and it will be important for us to maintain
access to these channels of distribution. We cannot assure you that we will
maintain access or that our access will allow us to maintain our historical
sales volume levels.
Distributors and retailers in the computer industry have from time to time
experienced significant fluctuations in their businesses, and a number have
failed. The insolvency or business failure of any significant distributor or
retailer of our products could have a material adverse effect on our business,
operating results and financial condition. We typically make sales to
distributors and retailers on unsecured credit, with terms that vary depending
upon the customer and the nature of the product. Although we have insolvency
risk insurance to protect against our customers' bankruptcy, insolvency or
liquidation, this insurance contains a significant deductible and a co-payment
obligation, and the policy does not cover all instances of non-payment. In
addition, while we maintain a reserve for uncollectible receivables, the actual
reserve may not be sufficient in every circumstance. As a result, a payment
default by a significant customer could have a material adverse effect on our
business, operating results and financial condition.
We are exposed to the risk of product returns and markdown allowances with
respect to our distributors and retailers. We allow distributors and retailers
to return defective, shelf-worn and damaged products in accordance with
negotiated terms, and also offer a 90-day limited warranty to our end users that
our products will be free from manufacturing defects. In addition, we provide
markdown allowances to our customers to manage our customers' inventory levels
in the distribution channel. Although we maintain a reserve for returns and
markdown allowances, and although our agreements with certain of our customers
place certain limits on product returns and markdown allowances, we could be
forced to accept substantial product returns and provide markdown allowances to
maintain our relationships with retailers and our access to distribution
channels. Product return and markdown allowances that exceed our reserves could
have a material adverse effect on our business, operating results and financial
condition. In this regard, our results of operations for the year ended December
31, 1999 were adversely affected by a higher than expected level of product
returns and markdown allowances, which reduced our net revenues. We may continue
to experience such high levels of product returns and markdown allowances in
future periods, which could have a material adverse effect on our business,
operating results and financial condition.
Shares Eligible for Future Sale
In 1999, we entered into two Stock Purchase Agreements with Titus, pursuant
to which Titus purchased 10,795,455 shares of our Common Stock from us for an
aggregate purchase price of $35 million. As part of the
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agreements, Titus' chairman and chief executive officer became our president,
and our chairman and chief executive officer exchanged 2 million personal shares
of our Common Stock for an agreed upon number of Titus shares. As a result of
these transactions, Titus currently owns approximately 43 percent of our
outstanding common stock.
In addition, Titus purchased 719,424 shares of Preferred Stock from us in
April 2000. The Preferred Stock is convertible by Titus, redeemable by us, and
accrues a six percent dividend per year. Titus may convert the Preferred Stock
at any time after May 2001, at which time the Preferred Stock shares would be
convertible into at least 7,194,240 shares of our Common Stock. Titus also
received warrants to purchase up to 500,000 shares of our Common Stock. If we
default in accordance with the line of credit agreement, and Titus is forced to
pay on their corporate guarantee, the Series A Preferred Stock may become
convertible into up to 42.8 million shares of our Common Stock.
We have agreed to register all of the unregistered shares of our Common
Stock held by Titus for resale under the Securities Act of 1933, as amended.
This registration could temporarily impair our ability to raise capital through
the sale of our equity securities, and, if such registered shares are sold,
could have a material adverse effect on the market price of our Common Stock.
Dependence upon Third Party Licenses
Many of our products, such as our Star Trek, Advanced Dungeons and Dragons
and the Caesar's Palace titles, are based on original ideas or intellectual
properties licensed from other parties. We cannot assure you that we will be
able to obtain new licenses, or renew existing licenses, on commercially
reasonable terms, if at all. For example, Viacom Consumer Products, Inc. has
granted the Star Trek license to another party upon the expiration of our rights
in 2002. If we are unable to obtain licenses for the underlying content that we
believe offers the greatest consumer appeal, we would either have to seek
alternative, potentially less appealing licenses, or release the products
without the desired underlying content, either of which could have a material
adverse effect on our business, operating results and financial condition. We
cannot assure you that acquired properties will enhance the market acceptance of
our products based on those properties. We also cannot assure you that our new
product offerings will generate net revenues in excess of their costs of
development and marketing or minimum royalty obligations, or that net revenues
from new product sales will meet or exceed net revenues from existing product
sales.
Dependence on Licenses from and Manufacturing by Hardware Companies
We are required to obtain a license to develop and distribute software for
each of the video game console platforms for which we develop products,
including a separate license for each of North America, Japan and Europe. We
have obtained licenses to develop software for the Sony PlayStation and
PlayStation 2, as well as video game platforms from Nintendo, Microsoft and
Sega.. We cannot assure you that we will be able to obtain licenses from
hardware companies on acceptable terms or that any existing or future licenses
will be renewed by the licensors. In addition, Sony Computer Entertainment,
Nintendo and Sega each have the right to approve the technical functionality and
content of the Company's products for such platform prior to distribution. Due
to the nature of the approval process, we must make significant product
development expenditures on a particular product prior to the time we seek these
approvals. Our inability to obtain these approvals could have a material adverse
effect on our business, operating results and financial condition.
Hardware companies such as Sony Computer Entertainment, Nintendo, Sega and
Microsoft may impose upon their licensees a restrictive selection and product
approval process, such that those licensees are restricted in the number of
titles that will be approved for distribution on the particular platform. While
we have prepared our future product release plans taking this competitive
approval process into consideration, if we incorrectly predict its impact and
fail to obtain approvals for all products in our development plans, this failure
could have a material adverse effect on our business, operating results and
financial condition. We depend upon Sony Computer Entertainment, Nintendo and
Sega for the manufacture of our products that are compatible with their
respective video game consoles. As a result, Sony Computer Entertainment,
Nintendo, Sega and Microsoft have the ability to raise prices for supplying
these products at any time and effectively control the timing of our release of
new titles for those platforms. PlayStation and Dreamcast products consist of
CD-ROMs and are typically delivered by Sony Computer Entertainment and Sega,
respectively, within a relatively short lead time. Other media may entail longer
lead times depending on the manufacturer. If we experience unanticipated delays
in the delivery of video game console products from Sony Computer Entertainment,
Sega, Nintendo or Microsoft, or if actual retailer and consumer
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demand for our interactive entertainment software differs from our forecast, our
business, operating results and financial condition could be materially
adversely affected.
Dependence on Key Personnel
Our success depends to a significant extent on the continued service of our
key product design, development, sales, marketing and management personnel, and
in particular on the leadership, strategic vision and industry reputation of our
founder and Chief Executive Officer, Brian Fargo. Our future success will also
depend upon our ability to continue to attract, motivate and retain highly
qualified employees and contractors, particularly key software design and
development personnel. Competition for highly skilled employees is intense, and
we cannot assure you that we will be successful in attracting and retaining such
personnel. Specifically, we may experience increased costs in order to attract
and retain skilled employees. Our failure to retain the services of Brian Fargo
or other key personnel or to attract and retain additional qualified employees
could have a material adverse effect on our business, operating results and
financial condition.
Risks Associated with International Operations; Currency Fluctuations
Our international net revenues accounted for 28 and 30 percent of our total
net revenues for the nine months ended September 30, 2000 and 1999,
respectively. In February 1999, we entered into an International Distribution
Agreement with Virgin for the exclusive distribution of our products in selected
international territories. We intend to continue to expand our direct and
indirect sales, marketing and product localization activities worldwide. This
expansion will require a great deal of management time and attention and
financial resources in order to develop improved international sales and support
channels. We cannot assure you, however, that we will be able to maintain or
increase international market demand for our products. Our international sales
and operations are subject to a number of inherent risks, including the
following:
. the impact of recessions in foreign economies
. the time and financial costs associated with translating and localizing
products for international markets
. longer accounts receivable collection periods
. greater difficulty in accounts receivable collection
. unexpected changes in regulatory requirements
. difficulties and costs of staffing and managing foreign operations
. foreign currency exchange rate fluctuations
. political and economic instability
. dependence on Virgin as an exclusive distributor for Europe.
These factors may have a material adverse effect on our future
international net revenues and, consequently, on our business, operating results
and financial condition. We currently do not engage in currency hedging
activities. Although exposure to currency fluctuations to date has been
insignificant, we cannot assure you that fluctuations in currency exchange rates
in the future will not have a material adverse effect on net revenues from
international sales and licensing, and thus on our business, operating results
and financial condition.
Risks Associated with New European Currency
On January 1, 1999, eleven of the fifteen member countries of the European
Union established fixed conversion rates between their existing sovereign
currencies and a new European currency, the euro. These eleven countries adopted
the euro as the common legal currency on that date. We make a significant
portion of our sales to these countries. Consequently, we anticipate that the
euro conversion will, among other things, create technical challenges to adapt
information technology and other systems to accommodate euro-denominated
transactions. The euro conversion may also limit our ability to charge different
prices for our products in different markets. While we anticipate that the
conversion will not cause major disruption of our business, the conversion may
have a material effect on our business or financial condition.
Protection of Proprietary Rights
We regard our software as proprietary and rely on a combination of patent,
copyright, trademark and trade secret laws, employee and third party
nondisclosure agreements and other methods to protect our proprietary rights.
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We own or license various copyrights and trademarks, and hold the rights to one
patent application related to the software engine for one of our titles. While
we provide "shrinkwrap" license agreements or limitations on use with our
software, it is uncertain to what extent these agreements and limitations are
enforceable. We are aware that some unauthorized copying occurs within the
computer software industry, and if a significantly greater amount of
unauthorized copying of our interactive entertainment software products were to
occur, our operating results could be materially adversely affected. While we
use copy protection on some of our products, we do not provide source code to
third parties unless they have signed nondisclosure agreements with respect to
that source code.
We rely on existing copyright laws to prevent unauthorized distribution of
our software. Existing copyright laws afford only limited protection. Policing
unauthorized use of our products is difficult, and software piracy can be a
persistent problem, especially in certain international markets. Further, the
laws of certain countries where our products are or may be distributed either do
not protect our products and intellectual property rights to the same extent as
the laws of the U.S. or are weakly enforced. Legal protection of our rights may
be ineffective in such countries, and as we leverage our software products using
emerging technologies, such as the Internet and on-line services, our ability to
protect our intellectual property rights and to avoid infringing others'
intellectual property rights may be diminished. We cannot assure you that
existing intellectual property laws will provide adequate protection for our
products in connection with these emerging technologies.
As the number of interactive entertainment software products in the
industry increases and the features and content of these products continues to
overlap, software developers may increasingly become subject to infringement
claims. Although we make reasonable efforts to ensure that our products do not
violate the intellectual property rights of others, we cannot assure you that
claims of infringement will not be made. Any such claims, with or without merit,
can be time consuming and expensive to defend. From time to time, we receive
communications from third parties regarding such claims. We cannot assure you
that existing or future infringement claims against us will not result in costly
litigation or require us to license the intellectual property rights of third
parties, either of which could have a material adverse effect on our business,
operating results and financial condition.
Entertainment Software Rating System; Governmental Restrictions
Legislation is periodically introduced at the state and federal levels in
the U.S. and in foreign countries to establish a system for providing consumers
with information about graphic violence and sexually explicit material contained
in interactive entertainment software products. Such a system would include
procedures for interactive entertainment software publishers to identify
particular products within defined rating categories and communicate these
ratings to consumers through appropriate package labeling and through
advertising and marketing presentations. In addition, many foreign countries
have laws that permit governmental entities to censor the content of certain
works, including interactive entertainment software. In certain instances, we
may be required to modify our products to comply with the requirements of these
governmental entities, which could delay the release of those products in those
countries. Those delays could have a material adverse effect on our business,
operating results and financial condition. While we currently voluntarily submit
our products to industry-created review boards and publish their ratings on our
game packaging, we believe that mandatory government-run interactive
entertainment software products rating systems eventually will be adopted in
many countries that represent significant markets or potential markets for our
products. Due to the uncertainties inherent in the implementation of such rating
systems, confusion in the marketplace may occur, and we are unable to predict
what effect, if any, such rating systems would have on our business. In addition
to such regulations, certain retailers have in the past declined to stock
certain of our products because they believed that the content of the packaging
artwork or the products would be offensive to the retailer's customer base.
While to date these actions have not had a material adverse effect on our
business, operating results or financial condition, we cannot assure you that
similar actions by our distributors or retailers in the future would not have a
material adverse effect on our business, operating results and financial
condition.
Control by Directors and Officers
Including Titus, our directors and executive officers beneficially own
voting stock with total of about 60 percent of the aggregate Common Stock voting
power in the Company. In addition, Titus holds Preferred Stock entitled to
7,619,047 votes, or approximately 20 percent of overall voting power. Together,
Titus and our directors and executive officers could, under certain
circumstances, gain substantial additional voting power. See "Factors Affecting
Future Performance -- Control by Titus". These stockholders can control
substantially all matters requiring our stockholders' approval, including the
election of directors (subject to our stockholders' cumulative
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voting rights) and the approval of mergers or other business combination
transactions. This concentration of voting power could discourage or prevent a
change in control.
Development of Internet/On-Line Services or Products
We seek to establish an on-line presence by creating and supporting sites
on the Internet. Our future plans envision conducting and supporting on-line
product offerings through these sites or others. Our ability to successfully
establish an on-line presence and to offer online products will depend on
several factors outside our control. These factors include the emergence of a
robust online industry and infrastructure and the development and implementation
of technological advancements to the Internet to increase bandwidth to the point
that will allow us to conduct and support on-line product offerings. Because
global commerce and the exchange of information on the Internet and other
similar open, wide area networks are relatively new and evolving, we cannot
assure you that a viable commercial marketplace on the Internet will emerge from
the developing industry infrastructure or that the appropriate complementary
products for providing and carrying Internet traffic and commerce will be
developed. We also cannot assure you that we will be able to create or develop a
sustainable or profitable on-line presence or that we will be able to generate
any significant revenue from on-line product offerings in the near future, if at
all. If the Internet does not become a viable commercial marketplace, or if this
development occurs but is insufficient to meet our needs or if such development
is delayed beyond the point where we plan to have established an on-line
service, our business, operating results and financial condition could be
materially adversely affected.
Risks Associated with Acquisitions
As part of our strategy to enhance distribution and product development
capabilities, we intend to review potential acquisitions of complementary
businesses, products and technologies. Some of these acquisitions could be
material in size and scope. While we will continue to search for appropriate
acquisition opportunities, we cannot assure you that the Company will be
successful in identifying suitable acquisition opportunities. If we do identify
any potential acquisition opportunity, we cannot assure you that we will
consummate the acquisition, and if the acquisition does occur, we cannot assure
you that it will be successful in enhancing our business or will increase our
earnings. As the interactive entertainment software industry continues to
consolidate, we may face increased competition for acquisition opportunities,
which may inhibit our ability to complete suitable transactions or increase
their cost. Future acquisitions could also divert substantial management time,
result in short term reductions in earnings or special transactions or other
charges and may be difficult to integrate with existing operations or assets.
We may, in the future, issue additional shares of Common Stock in
connection with one or more acquisitions, which may dilute our stockholders.
Additionally, with respect to future acquisitions, our stockholders may not have
an opportunity to review the financial statements of the entity being acquired
or to vote on these acquisitions.
Anti-Takeover Effects; Delaware Law and Certain Charter and Bylaw Provisions
Our Certificate of Incorporation and Bylaws, as well as Delaware corporate
law, contain certain provisions that could delay, defer or prevent a change in
control and could materially adversely affect the prevailing market price of our
Common Stock. Certain of these provisions impose various procedural and other
requirements that could make it more difficult for stockholders to take certain
corporate actions.
Stock Price Volatility
The trading price of our Common Stock has been and could continue to be
subject to wide fluctuations in response certain factors, including:
. quarter to quarter variations in results of operations
. our announcements of new products
. our competitors' announcements of new products
. our product development or release schedule
. general conditions in the computer, software, entertainment, media or
electronics industries
. changes in earnings estimates or buy/sell recommendations by analysts
. investor perceptions and expectations regarding our products, plans and
strategic position and those of our competitors and customers
. other events or factors
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In addition, the public stock markets experience extreme price and trading
volume volatility, particularly in high technology sectors of the market. This
volatility has significantly affected the market prices of securities of many
technology companies for reasons often unrelated to the operating performance of
the specific companies. These broad market fluctuations may adversely affect the
market price of our Common Stock.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not have any derivative financial instruments as of September 30,
2000. However, we are exposed to certain market risks arising from transactions
in the normal course of business, principally the risk associated with interest
rate fluctuations on our revolving line of credit agreement, and the risk
associated with foreign currency fluctuations. We do not hedge our interest rate
risk, or our risk associated with foreign currency fluctuations.
Interest Rate Risk
------------------
Our interest rate risk is immaterial due to the short maturity of the line
of credit agreement. We have no fixed rate debt.
Foreign Currency Risk
---------------------
Our earnings are affected by fluctuations in the value of our foreign
subsidiary's functional currency, and by fluctuations in the value of the
functional currency of our investment in a foreign company that is accounted for
under the equity method. Our risk associated with foreign exchange fluctuations
has been immaterial to date.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Company is involved in various legal proceedings, claims and
litigation arising in the ordinary course of business, including
disputes arising over the ownership of intellectual property rights
and collection matters. In the opinion of management, the outcome of
known routine claims will not have a material adverse effect on the
Company's business, financial condition or results of operations.
Item 5. Other Information
In August 2000, the Company received a determination from a Nasdaq
Listing Qualifications Panel to continue the listing of the Company's
Common Stock on the Nasdaq National Market provided that the Company
fulfilled certain conditions, including having net tangible assets of
at least $8.3 million at September 30, 2000. The Company's net
tangible assets were $9.9 million at September 30, 2000, exceeding
the listing requirements, and the Company has fulfilled the other
conditions required by Nasdaq.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits - The following exhibits are filed as part of this report:
Exhibit
-------
Number Exhibit Title
------- ------------
27.1 Financial data schedule for the nine-month period ended
September 30, 2000.
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SIGNATURES
Pursuant to 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.
INTERPLAY ENTERTAINMENT CORP.
Date: November 10, 2000 By: /s/ BRIAN FARGO
-----------------------
Brian Fargo,
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
Date: November 10, 2000 By: /s/ MANUEL MARRERO
---------------------
Manuel Marrero,
Chief Financial Officer
(Principal Financial and
Accounting Officer)
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