U.S. Securities and Exchange Commission
Washington, D.C. 20549
FORM 10-QSB
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1998
Commission file number 000-29750
INTERACTIVE MAGIC, INC.
(Exact name of small business issuer as specified in its charter)
North Carolina 56-2092059
(State of incorporation) (I.R.S. Employer Identification Number)
215 Southport Drive, Suite 1000
Morrisville, North Carolina 27560
(Address of principal executive office)
(919) 461-0722
(Issuer's telephone number)
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act 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 |_| No |X|
As of August 31, 1998 (the most recent practicable date), there were
9,783,699 shares of the issuer's Common Stock, $.10 par value per share,
outstanding.
Transitional Small Business Disclosure Format (check one)
Yes |_| No |X|
<PAGE>
<TABLE>
<CAPTION>
<S> <C>
INTERACTIVE MAGIC, INC.
Form 10-QSB Quarterly Report
INDEX
-----
PART I FINANCIAL INFORMATION PAGE
----
Item 1 Financial Statements 3
Item 2 Management's Discussion and Analysis of Financial
Condition and Results of Operations 15
PART II OTHER INFORMATION 23
Item 1 Legal Proceedings 23
Item 2 Changes in Securities and Use of Proceeds 23
Item 3 Defaults Upon Senior Securities 24
Item 4 Submission of Matters to a Vote of Security Holders 24
Item 5 Other Information 24
Item 6 Exhibits and Reports on Form 8-K 25
SIGNATURES 26
EXHIBIT INDEX 27
</TABLE>
2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
<S> <C>
Interactive Magic, Inc.
Condensed Consolidated Balance Sheets
(IN THOUSANDS, EXCEPT SHARE DATA)
JUNE 30, DECEMBER 31,
1998 1997
--------------------- ---------------------
(UNAUDITED) (AUDITED)
ASSETS
Current Assets:
Cash and cash equivalents $ 344 $ 384
Accounts receivable, net 4,994 2,920
Inventories 801 637
Advance royalties 1,676 1,989
Software development costs 1,265 425
Other current assets 147 109
--------------------- ---------------------
Total current assets 9,227 6,464
Property and equipment, net 1,092 1,196
Other noncurrent assets 59 87
===================== =====================
Total assets $ 10,378 $7,747
===================== =====================
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Accounts payable and accrued expenses $ 2,915 $ 2,776
Royalties and commissions payable 1,150 858
Lines of credit 4,883 3,983
Current portion of long-term debt 250 745
Current portion of capital lease obligations 35 35
--------------------- ---------------------
Total current liabilities 9,233 8,397
Noncurrent liabilities:
Accrued interest payable to related parties 841 982
Long-term debt, less current portion 3,805 3,759
Capital lease obligations 18 38
Notes payable to related parties 870 3,470
--------------------- ---------------------
Total noncurrent liabilities 5,534 8,249
</TABLE>
3
<PAGE>
<TABLE>
<CAPTION>
<S> <C>
Interactive Magic, Inc.
Condensed Consolidated Balance Sheets (continued)
(IN THOUSANDS, EXCEPT SHARE DATA)
JUNE 30, DECEMBER 31,
1998 1997
--------------------- ---------------------
(UNAUDITED) (AUDITED)
Series C Redeemable Convertible Preferred Stock, $.10 par value;
132,744 shares authorized, issued and outstanding at June 30, 1998 600 -
STOCKHOLDERS' DEFICIT:
Series A Convertible Preferred Stock, $.10 par value; 82,634 shares
authorized, issued and outstanding at June 30, 1998 and December
31, 1997 8 8
Series B Convertible Preferred Stock, $.10 par value; 778,746 shares
authorized, issued and outstanding at June 30, 1998 and December
31, 1997 78 -
Class A Common Stock, $.10 par value; 10,000,000 shares authorized, 3,414,446
and 3,145,696 shares issued and outstanding at June 30,
1998 and December 31, 1997, respectively 341 314
Class B Common Stock, $.10 par value; 10,000,000 shares authorized, 601,457
and 7,875 shares issued and outstanding at June 30, 1998
and December 31, 1997, respectively 60 1
Additional paid-in capital 10,470 5,047
Cumulative currency translation adjustment (80) (59)
Accumulated deficit (15,866) (14,210)
--------------------- ---------------------
Total stockholders' deficit (4,989) (8,899)
===================== =====================
Total liabilities and stockholders' deficit $ 10,378 $ 7,747
===================== =====================
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
balance sheets.
4
<PAGE>
<TABLE>
<CAPTION>
<S> <C>
Interactive Magic, Inc.
Condensed Consolidated Statements of Operations
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------- --------------- ---------------- ---------------
1998 1997 1998 1997
--------------- --------------- ---------------- ---------------
Net revenues:
CD-ROM product sales $ 2,495 $ 1,516 $ 6,552 $ 4,915
Online sales 426 455 784 812
Royalties and licenses 901 40 1,399 241
--------------- --------------- ---------------- ---------------
Total net revenues 3,822 2,011 8,735 5,968
--------------- --------------- ---------------- ---------------
Cost of revenues:
Cost of products sold 604 486 1,572 1,252
Royalties and amortized software costs 461 118 1,370 767
--------------- --------------- ---------------- ---------------
Total cost of revenues 1,065 604 2,942 2,019
--------------- --------------- ---------------- ---------------
Gross profit 2,757 1,407 5,793 3,949
Operating expenses:
Sales and marketing 2,048 1,893 3,715 3,535
Product development 858 858 1,961 1,717
General and administrative 570 400 1,019 998
--------------- --------------- ---------------- ---------------
Total operating expenses 3,476 3,151 6,695 6,250
--------------- --------------- ---------------- ---------------
Operating loss (719) (1,744) (902) (2,301)
--------------- --------------- ---------------- ---------------
Other expense:
Interest expense - third parties 230 173 430 319
Interest expense - related parties 71 180 178 334
Other 18 110 18 109
--------------- --------------- ---------------- ---------------
Total other expense 319 463 626 762
--------------- --------------- ---------------- ---------------
Loss before income taxes (1,038) (2,207) (1,528) (3,063)
Income tax (expense) benefit - 1 (128) 32
--------------- --------------- ---------------- ---------------
Net loss $(1,038) $(2,206) $(1,656) $(3,031)
=============== =============== ================ ===============
Basic net loss per share $ (0.27) $ (0.70) $ (0.46) $ (0.96)
=============== =============== ================ ===============
Shares used in computing basic net loss per share 3,778,979 3,152,458 3,605,233 3,152,283
=============== =============== ================ ===============
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
<TABLE>
<CAPTION>
<S> <C>
Interactive Magic, Inc.
Condensed Consolidated Statements of Cash Flows
(UNAUDITED)
(IN THOUSANDS)
FOR THE SIX MONTHS ENDED JUNE 30,
1998 1997
----------------- -----------------
OPERATING ACTIVITIES:
Net loss $(1,656) $(3,031)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization 205 220
Amortization of capitalized software development costs 275 73
Issuance of common stock for services - 15
Noncash interest expense 51 -
Changes in operating assets and liabilities:
Accounts receivable (2,074) (2)
Inventories (164) (325)
Advance royalties 313 (323)
Other current and noncurrent assets (10) (134)
Accounts payable and accrued expenses 139 644
Royalties and commissions payable 292 (43)
Accrued interest 178 398
----------------- -----------------
Net cash used in operating activities (2,451) (2,508)
----------------- -----------------
INVESTING ACTIVITIES:
Purchase of property and equipment (101) (253)
Software development costs (1,115) (560)
----------------- -----------------
Net cash used in investing activities (1,216) (813)
----------------- -----------------
FINANCING ACTIVITIES:
Proceeds from long-term debt - 2,890
Payments on long-term debt (500) -
Proceeds from notes payable to related parties - 200
Net borrowings from lines-of-credit 900 308
Payments on capital lease obligations (20) (27)
Proceeds from issuance of common and preferred stock 3,268 1
----------------- -----------------
Net cash provided by financing activities 3,648 3,372
----------------- -----------------
</TABLE>
6
<PAGE>
<TABLE>
<CAPTION>
<S> <C>
Interactive Magic, Inc.
Condensed Consolidated Statements of Cash Flows (continued)
(UNAUDITED)
(IN THOUSANDS)
FOR THE SIX MONTHS ENDED JUNE 30,
1998 1997
----------------- -----------------
Effect of currency exchange rate changes on cash and cash equivalents (21) 5
----------------- -----------------
Net (decrease) increase in cash and cash equivalents (40) 56
Cash and cash equivalents at beginning of period 384 292
----------------- -----------------
Cash and cash equivalents at end of period 344 348
================= =================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 472 $ 272
Cash paid for income taxes $ 2 $ 3
================= =================
NONCASH INVESTING AND FINANCING ACTIVITIES:
Conversion of notes payable into common and preferred stock $ 2,600 $ -
Issuance of common stock in settlement of accrued interest payable to
related parties $ 319 $ -
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
7
<PAGE>
Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements
(UNAUDITED)
1. BASIS OF PRESENTATION:
The condensed consolidated financial statements include the accounts of
Interactive Magic, Inc. (the "Company"), a North Carolina corporation, and its
wholly owned subsidiaries, iMagicOnline Corporation, Interactive Magic Ltd. and
Interactive Magic GmbH. All significant intercompany accounts and transactions
have been eliminated.
While the financial information furnished is unaudited, the condensed
consolidated financial statements included in this report reflect all
adjustments (consisting only of normal recurring adjustments) which the Company
considers necessary for the fair presentation of the results of operations for
the interim periods covered and of the financial condition of the Company at the
date of the interim balance sheet. The results for interim periods are not
necessarily indicative of the results for the entire year. The condensed
consolidated financial statements should be read in conjunction with the
Interactive Magic, Inc. consolidated financial statements for the year ended
December 31, 1997 included in its Registration Statement on Form SB-2 declared
effective on July 21, 1998.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures 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.
REVENUE RECOGNITION
Revenue from CD-ROM product sales is recognized at the time of product
shipment. Revenue from online sales is recognized at the time the game is played
and is based upon actual usage by the customer on an hourly basis. Revenue from
royalties and licenses is recognized when earned under the terms of the relevant
agreements with original equipment manufacturers ("OEMs"), international
distributors and other third parties. With respect to license agreements that
provide customers the right to multiple copies in exchange for guaranteed
amounts, net revenue is recognized upon delivery of the product master or the
first copy. Per copy royalties on sales that exceed the guarantee are recognized
as earned. The Company accepts product returns and
8
<PAGE>
Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
(UNAUDITED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):
provides price protection on certain unsold merchandise. Revenue is recorded net
of an allowance for estimated future returns, markdowns, price protection and
warranty costs. Such reserves are based upon management's evaluation of
historical experience, current industry trends and estimated costs.
BASIC NET LOSS PER SHARE AND PRO FORMA NET LOSS PER SHARE
Historical basic net loss per share has been calculated in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per
Share". SFAS No. 128 requires companies to compute earnings Per share under two
different methods (basic and diluted). Basic net loss per share is calculated by
dividing net loss by the weighted average shares of common stock outstanding
during the period.
Pro forma net loss per share, as presented in the following table, has been
calculated as described above and also gives effect to the conversion of the
Series A and Series B Convertible Preferred Stock, the Series C Redeemable
Convertible Preferred Stock and the exercise of certain options and warrants
that occurred in connection with the Company's initial public offering in July
1998 (using the as-if converted method).
A reconciliation of shares used in the calculation of basic net loss per
share and pro forma net loss per share follows (IN THOUSANDS, EXCEPT SHARE AND
PER SHARE DATA):
<TABLE>
<CAPTION>
<S> <C>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------------- ---------------------------
1998 1997 1998 1997
--------------- ------------- ------------- -------------
(UNAUDITED) (UNAUDITED)
Net loss $ (1,038) $ (2,206) $ (1,656) $ (3,031)
=============== ============= ============= =============
Weighted average shares of common stock outstanding
(shares used in computing basic net loss per share) 3,778,979 3,152,458 3,605,233 3,152,283
Basic net loss per share $ (0.27) $ (0.70) $ (0.46) $ (0.96)
=============== ============= ============= =============
Shares used in computing basic net loss per share 3,778,979 3,152,458 3,605,233 3,152,283
Adjustment to reflect the effect of the assumed
conversion of the Series A and Series B Convertible
Preferred Stock 2,128,283 2,128,283 2,128,283 2,128,283
</TABLE>
9
<PAGE>
Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
(UNAUDITED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):
<TABLE>
<CAPTION>
<S> <C>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------- --------------------------------
1998 1997 1998 1997
--------------- --------------- ---------------- ---------------
(UNAUDITED) (UNAUDITED)
Adjustment to reflect the effect of the assumed
conversion of the Series C Redeemable
Convertible Preferred Stock 132,744 132,744 132,744 132,744
Adjustment to reflect the exercise of certain
options and warrants in connection with the
Company's initial public offering 516,769 929,123 516,769 929,123
--------------- --------------- ---------------- ---------------
Shares used in computing pro forma net loss per
share 6,556,775 6,342,608 6,383,029 6,342,433
=============== =============== ================ ===============
Pro forma net loss per share $ (0.16) $ (0.35) $ (0.26) $ (0.48)
=============== =============== ================ ===============
</TABLE>
Had the Company been in a net income position, diluted earnings per share
would have been presented and would have included the shares used in the
computation of pro forma net loss per share as well as additional potential
common shares related to outstanding options and warrants. The diluted earnings
per share computation is not included, as all potential common shares are
antidilutive. The Company evaluated the requirements of the Securities and
Exchange Commission Staff Accounting Bulletin No. 98 ("SAB 98"), and concluded
that there are no nominal issuances of common stock or potential common stock
which would be required to be shown as outstanding for all periods as outlined
in SAB 98.
10
<PAGE>
Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
(UNAUDITED)
3. LINES OF CREDIT:
On April 30, 1998, the Company closed on a $5 million line of credit
bearing an interest rate of the bank's prime plus 2%. Borrowings on the line of
credit are limited to the lesser of $5 million or 65% of the Company's
outstanding eligible receivables and inventory. Borrowings on the line of credit
are collateralized by the Company's accounts receivable, inventory, and
intellectual property, and the proceeds will be used to extinguish certain
existing debt and provide additional working capital. The line of credit expires
on April 30, 1999. As of June 30, 1998, borrowings on the line were $2.1
million. The Company maintains other lines of credit as described in its Form
SB-2 declared effective on July 21, 1998.
4. NOTES PAYABLE TO RELATED PARTIES:
Notes payable to related parties consist of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
<S> <C>
JUNE 30, DECEMBER 31,
1998 1997
-------------------- --------------------
(UNAUDITED) (AUDITED)
Note payable to a stockholder, due on demand after January 1,
1999, interest at 14% per annum $ - $ 600
Note payable to a stockholder, principal and interest due on demand after
January 1, 1999, stated interest at 15% per annum
until November 17, 1996, 17% thereafter - 1,000
Note payable to a stockholder, principal and interest due on
demand after January 1, 1999, stated interest at 15% per annum
until January 6, 1997, 17% thereafter - 1,000
Note payable to related party, principal and interest due July
1, 1999, interest at 10% per annum 870 870
-------------------- --------------------
$ 870 $ 3,470
==================== ====================
</TABLE>
On February 4, 1998, the $600,000 and the two $1 million notes payable to
stockholders were converted into 132,744 shares of Series C Redeemable
Convertible Preferred Stock and 442,478 shares of Class B Common Stock,
respectively. In connection with the Company's July 1998 initial public
offering, the Series C Redeemable Convertible Preferred Stock was converted into
132,744 shares of common stock. Utilizing proceeds from the Company's initial
public offering, the $870,000 note payable to a related party was paid in full.
11
<PAGE>
Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
(UNAUDITED)
5. LONG-TERM DEBT:
Long-term debt, other than to related parties, consists of the following
(IN THOUSANDS):
<TABLE>
<CAPTION>
<S> <C>
JUNE 30, DECEMBER 31,
1998 1997
----------------------------------------
(UNAUDITED) (AUDITED)
Note payable due January 31, 1998, stated interest at prime
plus 2% until an additional round of equity investment is received by
the Company at which time the interest will be prime plus 4%,
collateralized by property and equipment (net of
unamortized discount of $5 at December 31, 1997) $ - $ 495
Subordinated note payable due March 24, 2002, stated interest
at 13.5% per annum, collateralized by property, equipment and inventory
(net of unamortized discount of $245 and $276 at June 30, 1998 and
December 31, 1997, respectively) 2,755 2,724
Note payable due January 9, 1998, stated interest rate at prime,
collateralized by a personal guarantee of the Company's major
shareholder 250 250
Junior, subordinated note payable, due August 30, 2002, interest
payable in arrears every six months, at stated interest rate of 11% per
annum for the first twelve months, 12.0% per annum for next twelve months,
and 12.5% thereafter until maturity, collateralized by the assets of
the Company (net of unamortized discount of $150
and $165 at June 30, 1998 and December 31, 1997, respectively) 1,050 1,035
----------------------------------------
4,055 4,504
Current portion (250) (745)
----------------------------------------
Long-term debt, less current portion $ 3,805 $ 3,759
========================================
</TABLE>
All of the aforementioned long-term debt was paid in full utilizing proceeds
from the Company's July 1998 initial public offering.
12
<PAGE>
Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
(UNAUDITED)
6. EMPLOYEE STOCK PLANS:
During May 1998, the Company's 1998 Stock Plan (the "Plan") was adopted by
the Board of Directors and approved by the shareholders of the Company. The
Company anticipates that no future grants will be made under the Company's 1995
incentive stock plans after the effective date of the Plan. A total of 800,000
shares of Common Stock have been reserved for issuance under the Plan. The Plan
provides for grants to employees of the Company of incentive stock options. In
addition, the Plan provides for grants of nonqualified stock options and stock
purchase rights to employees, directors and consultants of the Company. The Plan
is administered by the Board of Directors or by a Committee appointed by the
Board. The administrator determines the terms of options and stock purchase
rights granted, including the exercise price and the number of shares subject to
the option or stock purchase right. The exercise price of incentive stock
options granted under the Plan must be at least equal to the fair market value
of the Company's Common Stock on the date of the grant. The maximum term of
options granted under the Plan is 10 years.
During May 1998, the Company's 1998 Employee Stock Purchase Plan (the
"Purchase Plan") was adopted by the Company's Board of Directors and approved by
the Company's shareholders. The Purchase Plan is intended to qualify under
Section 423 of the Internal Revenue Code of 1986, as amended. The Company has
reserved 500,000 shares of Common Stock for issuance under the Purchase Plan.
Under the Purchase Plan, an eligible employee may purchase shares of Common
Stock from the Company through payroll deductions of up to 10% of his or her
base compensation, not to exceed $25,000 per year, at a price per share equal to
85% of the fair market value of a share of the Company's Common Stock on the
last day of the offering period. The maximum number of shares that an employee
may purchase in any offering period is 2,500 shares. Any employee who is
customarily employed for at least 20 hours per week, and more than five months
per calendar year and who is employed on or before the commencement date of an
offering period is eligible to participate in the Purchase Plan.
7. SUBSEQUENT EVENTS:
On July 1, 1998, the Company effected a one-for-two reverse stock split of
the Company's capital stock in connection with the Company's reincorporation in
North Carolina. All references in the financial statements with regard to number
of shares of each class of stock have been restated to reflect the reverse stock
split for all periods presented.
13
<PAGE>
Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
(UNAUDITED)
7. SUBSEQUENT EVENTS (CONTINUED):
On July 27, 1998, the Company consummated an initial public offering of
2,600,000 shares of its Common Stock at an initial public offering price of
$8.00 per share. During August 1998, BlueStone Capital Partners, L.P. and Royce
Investment Group, Inc. (collectively, the "underwriters") exercised in full
their overallotment option to purchase an additional 390,000 shares of the
Company's common stock at the initial public offering price. All of such shares
were sold by the Company. The net proceeds to the Company from the offering were
approximately $21.3 million. Concurrent with the closing of the offering, all of
the Company's outstanding preferred stock was converted into 2,261,027 shares of
common stock. As presented in the Company's Registration Statement on Form SB-2
declared effective July 21, 1998, the Company utilized proceeds from the
offering to repay $7.2 million of indebtedness. The remaining proceeds received
by the Company from such offering were invested in short-term, investment-grade,
interest-bearing instruments. See "Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations-Liquidity and Capital
Resources".
14
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Form 10-QSB, including Management's Discussion and Analysis of
Financial Condition and Results of Operations, contains forward looking
statements within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934 which are based upon current
expectations and involve a number of risks and uncertainties. There are a number
of important factors that could cause actual results to differ materially from
those expressed in any forward-looking statements made by the Company. These
factors include, but are not limited to, risks of delays in development and
introduction of new products, dependence on new product introductions which
achieve significant market acceptance and the uncertainties of consumer
preferences, the rate and degree of market acceptance of online gaming, the
ability to negotiate profitable terms for online gaming products and services,
dependence on third party software developers for a significant portion of new
products, risks of rapid technological change and platform changes, intense
competition, seasonality, dependence upon third party distribution and risks
associated with international business. See Exhibit 99.01 for additional factors
that could cause the Company's actual results to differ.
OVERVIEW
The Company develops, publishes and distributes interactive real-time 3D
simulation and strategy entertainment software. The Company generates revenues
primarily from delivering its CD-ROM products for retail sale through its
worldwide distribution network and from subscription and hourly fees for play of
its online product. The Company also generates revenues from licensing its
CD-ROM products to OEMs, distributors outside of North America and other third
parties. Since inception, the Company has published over 30 CD-ROM products
which have been distributed through more than 15,000 retail outlets in over 30
countries. Additionally, the Company has sold over 1.5 million hours of online
game time over the Internet to players in more than 70 countries.
In April 1997, the Company acquired Interactive Creations, Inc, ("ICI"), a
leader in the development and delivery of interactive large-scale multiplayer
real-time online games. The Company exchanged 655,696 shares of the Company's
Common Stock for all of the outstanding shares of ICI. This transaction was
accounted for as a pooling of interests; accordingly, the Company restated all
historical financial data to include the historical financial data of ICI. In
connection with the ICI acquisition, the Company acquired ICI's WARBIRDS product
and the associated MEGAplayer technology for which a patent application has been
filed. In fiscal year 1997, the Company published 11 CD-ROM products while
developing new products incorporating the technology acquired from ICI. In the
first six months of 1998, the Company has published 10 CD-ROM products and is
preparing for the third quarter 1998 release of a second online product, DAWN OF
ACES.
15
<PAGE>
The Company recognizes net revenues from the sale of CD-ROM products at the
time of product shipment. Net revenues from CD-ROM product sales are reflected
after the deduction of what management believes to be an appropriate allowance
for returns, markdowns, price protection and warranty costs. Revenue from usage
of its online product is recognized at the time the game is played and is based
upon actual usage by the customer on an hourly basis. Revenues from licenses to
OEMs, international distributors and other third parties are recognized when
earned under the terms of the relevant agreements. Subject to certain
limitations, the Company accepts product returns and provides price protection
on certain unsold merchandise. With respect to license agreements that provide
customers the right to multiple copies in exchange for guaranteed amounts, net
revenues are recognized upon delivery of the product master or the first copy.
Per copy royalties on sales that exceed the guarantee are recognized as earned.
The Company's internal product development costs incurred prior to
establishing technological feasibility are expensed in accordance with the
Financial Accounting Standards Board Statement of Financial Accounting Standards
("SFAS") No. 86, "Accounting for the Costs of Computer Software to be Sold,
Leased or Otherwise Marketed." In accordance with SFAS No. 86, the Company
capitalizes product development costs subsequent to establishing technological
feasibility and amortizes previously capitalized product development costs by
using: (i) the revenue curve method; or (ii) the straight-line method over the
estimated economic life of the product, which typically ranges from six months
to two years.
In addition to the internal development of products, the Company enters
into publishing agreements with third-party developers pursuant to which the
Company typically advances royalties before the product is published. After
product release, the Company expenses advance royalties based on product sales
and pays the developer incremental royalties after the advance royalties have
been fully expensed. The Company also incurs internal costs related to product
development by third parties, including costs related to supervising the
development process for quality assurance and developing technology for
incorporation into third-party products. The Company typically expenses these
costs as a product development expense.
The Company has experienced significant losses in prior years, resulting
primarily from overhead and other costs incurred in the development and growth
of the Company. Moreover, the Company expects to incur substantial up-front
expenditures and operating costs in connection with the expansion of its
marketing efforts and product lines, which may result in significant losses for
the foreseeable future. The Company's plan of operation is to increase its
online and retail product lines and to expand its distribution network. This
plan is intended to increase sales volume of both online and retail products and
to enable the Company to improve financial results. The Company intends to
increase net revenues from online products by offering additional content over
the Company's online service and to utilize distribution partners, primarily
online service providers ("OSPs") and Internet service providers ("ISPs") to
enable the Company to access additional customers. The extent and timing of
revenues generated by online games are uncertain, however, because this market
is emerging and depends upon a number of variables, including the availability
of an infrastructure for providing local access to wide area networks with
16
<PAGE>
acceptable response times and consumer acceptance of such networks as a medium
for playing multi-user simulation and strategy games. The Company intends to
increase net revenues from CD-ROM sales by offering more titles and increasing
the Company's brand awareness. Although the Company believes that this plan of
operation will lead to improved financial results, there can be no assurance
that the Company will be able to successfully implement its growth and business
strategies, that its revenues will continue to increase in the future or that it
will be able to achieve or sustain profitable operations.
The Company has experienced, and expects to continue to experience,
significant variability in its quarterly and annual results due to a number of
factors, many of which are outside of the Company's control. The Company
believes that one of the factors in such variability is the fluctuation in the
rates at which OEMs purchase the Company's products and services, which is
impacted by OEMs' own business cycles. Another factor in such variability is the
timing of introduction of new products. From time to time, the introduction of
new products by the Company has been delayed beyond the Company's projected
shipping date. In each instance, such delays have resulted in increased costs
and delayed revenues. Because future revenues are dependent on the timely
introduction of new product offerings, any such future delays could have a
material adverse effect on the Company's business, operating results and
financial condition. The Company's expense levels are based, in significant
part, on expectations of future revenues. Consequently, if revenue levels are
below expectations, expense levels could be disproportionately high as a
percentage of total revenues, and operating results would be immediately and
adversely affected.
RESULTS OF OPERATIONS
NET REVENUES. Net revenues increased by 90.1% to $3.8 million for the three
months ended June 30, 1998 from $2.0 million for the three months ended June 30,
1997. Net revenues for the six months ended June 30, 1998 increased by 46.4% to
$8.7 million from $6.0 million for the same period in 1997. The increases in
both the second quarter and six-month periods were primarily due to increases in
net revenues from CD-ROM product sales, licensing agreements with third parties
and royalties paid by distributors of certain of the Company's CD-ROM products.
Second quarter and year-to-date net revenues from CD-ROM product sales increased
due to the greater number of new product releases during each of the first and
second quarters of 1998 as compared to the comparable periods of 1997. The
increase in net revenues attributable to increases in CD-ROM unit sales in each
period was partially offset by a decrease in the average unit sales price in the
three and six months ended June 30, 1998 as compared to the comparable periods
in 1997. Royalty and license revenues for the three months and six months ended
June 30, 1998 increased due to the Company's emphasis, including the dedication
of specific resources (primarily employees), on developing royalty and licensing
relationships for its products. Net revenues attributable to the Company's
online service remained relatively constant in the three and six-month periods
of 1998 versus the comparable periods of 1997 as the Company focused on building
the infrastructure for delivery of additional games and developing those games.
17
<PAGE>
COST OF REVENUES. Cost of revenues consist of costs of products sold
(including cost of Internet access) and royalties and amortization of software
development costs. Cost of revenues in the second quarter of 1998 increased by
76.3% to $1.1 million from $0.6 million in the same period of 1997, representing
gross margins of 72.1% and 70.0%, respectively. Cost of revenues for the six
months ended June 30, 1998 increased by 45.7% to $2.9 million from $2.0 million
in the same period of 1997, representing gross margins of 66.3% and 66.2%,
respectively. The cost of products sold increased in the three months and six
months ended June 30, 1998 by $0.1 million (24%) and $0.3 million (26%),
respectively, due to an increase in unit sales in both periods over the unit
sales in the comparable periods in 1997. Royalties and amortized costs increased
in the three months and six months ended June 30, 1998 by $0.3 million (291%)
and $0.6 million (79%), respectively, due primarily to the significant increase
in titles released in the 1998 periods, as well as the increase in titles
developed internally in the 1998 periods, versus the comparable 1997 periods.
The increase in gross margins for both the quarter and six month comparisons was
primarily due to increased product licensing revenues, which have substantially
higher gross margins than CD-ROM product sales, partially offset by the decrease
in average unit sales price of CD-ROM products referred to in "NET REVENUES"
above.
OPERATING EXPENSES
SALES AND MARKETING. Sales and marketing expenses for the second quarter of
1998 increased by 8.2% to $2.0 million from $1.9 million in the same period of
1997, representing 53.6% and 94.1%, respectively, of total net revenues. Sales
and marketing expenses for the six months ended June 30, 1998 increased to $3.7
million from $3.5 million from the same period of 1997, representing 42.5% and
59.2%, respectively, of total net revenues. The decrease in sales and marketing
expense as a percentage of net revenues was due primarily to the larger revenue
base in 1998.
PRODUCT DEVELOPMENT. Product development expenses for the second quarter of
1998 remained flat at $858,000 from the same period of 1997, representing 22.4%
and 42.7%, respectively, of total net revenues. Product development expenses for
the six months ended June 30, 1998 increased to $2.0 million from $1.7 million
in the same period of 1997, representing 22.4% and 28.8%, respectively, of total
net revenues. The decreases in the percentage of net revenues for both the
quarter and six-month comparison periods were primarily the result of increases
in the amount of total net revenues and capitalized product development costs.
The Company capitalized $532,000 (38.3% of gross product development costs) for
the second quarter 1998 and $305,000 (26.2% of gross product development costs)
for same period of 1997. The Company capitalized $1.1 million (36.2% of gross
product development costs) for the six months ended June 30, 1998 and $560,000
(24.6% of gross product development costs) for the same period of 1997. The
increase in the capitalized product development costs for the three and six
months ended June 30, 1998 versus the comparable periods in 1997 is attributable
to the greater number of products being developed internally.
18
<PAGE>
GENERAL AND ADMINISTRATIVE. General and administrative expenses for the
second quarter of 1998 increased to $570,000 from $400,000 in the same period in
1997, representing 14.9% and 19.9%, respectively, of total net revenues. General
and administrative expenses for the six months ended June 30, 1998 remained flat
at $1.0 million from the same period in 1997, representing 11.7% and 16.7%,
respectively, of total net revenues. The increase in general and administrative
expenses of $0.2 million for the three months ended June 30, 1998 versus the
comparable period in 1997, is attributable to the Company's addition of
employees and office space to support its growth. Increases in similar costs
during the six months ended June 30, 1998 versus the comparable period in 1997,
were partially offset by substantial one-time expenses during the 1997 period
for new employee recruitment fees and the expenses related to the acquisition of
ICI. The decreases in general and administrative expenses as a percentage of net
revenues were due primarily to higher total net revenues in both the quarter and
six-month comparison periods.
OTHER EXPENSE. Other expense, comprised primarily of interest expense,
decreased to $319,000 for the second quarter of 1998 from $463,000 for the
comparable period in 1997. Other expense for the six months ended June 30, 1998
decreased to $626,000 from $762,000 for the comparable period in 1997. The
decreases in both the quarter and six-month comparison periods were primarily
due to the 1998 conversion of certain shareholder notes into common and
preferred stock. In addition, the Company reduced its high interest bearing debt
during 1998 utilizing proceeds from its private placement of preferred stock in
February 1998.
INCOME TAX (EXPENSE) BENEFIT. The Company recorded no income tax expense
for the second quarter 1998 and $128,000 of income tax expense for the six
months ended June 30, 1998. The Company recorded an income tax benefit of
approximately $1,000 and $32,000 for the three months ended and six months ended
June 30, 1997, respectively. The tax benefit recorded in 1997 was due to a
refund from a net operating loss carryforward. The Company recorded income tax
expense during the six months ended June 30, 1998 because its United Kingdom
subsidiary generated taxable income during such period.
LIQUIDITY AND CAPITAL RESOURCES
The Company's capital requirements have been and will continue to be
significant, and, to date, its cash requirements have exceeded its cash flow
from operations. The Company historically has satisfied cash requirements
through borrowings, the private sale of equity securities, customer advances and
capital lease financings.
Net cash used in operating activities remained flat at $2.5 million for
both the six-month periods ended June 30, 1998 and 1997. Net cash used in
operations during the six months ended June 30, 1998 is due primarily to the
Company's operating loss and an increase in accounts receivable. Accounts
receivable grew by $2.1 million from December 31, 1997 to June 30, 1998,
primarily due to increased revenues. Net cash used in operations during the
comparable period in 1997 is attributable primarily to the loss from operations
offset by various changes in operating assets and liabilities.
19
<PAGE>
Net cash used in investing activities was $1.2 million and $813,000 for the
six months ended June 30, 1998 and 1997, respectively. Net cash used in 1998
investing activities was primarily due to a $1.1 million increase in capitalized
software development costs. Net cash used in 1997 investing activities primarily
reflected capitalized software development costs and capital expenditures for
fixed assets.
Net cash provided by financing activities was $3.6 million and $3.4 million
for the six months ended June 30, 1998 and 1997, respectively. During 1998, net
cash provided by financing activities consisted primarily of proceeds from
private sales of common and preferred stock and borrowings on revolving lines of
credit. The Company's 1997 funding consisted primarily of proceeds from the
issuance of a $2.9 million long-term note payable, the issuance of a related
party note payable and borrowings on its line of credit.
On April 30, 1998, the Company closed on a one-year $5.0 million revolving
line of credit bearing an interest rate of prime plus 2%. Borrowings on the line
of credit are limited to the lesser of $5.0 million or 65% of the Company's
outstanding eligible receivables and inventory. Borrowings on the line of credit
are collateralized by the Company's accounts receivable, inventory, and
intellectual property. As of June 30, 1998, borrowings on the line were $2.1
million, which the Company used to extinguish certain high-interest debt and
provide additional working capital.
The Company maintains a revolving line of credit arrangement with a bank
for up to $2.8 million. The principal balance outstanding at any point in time
is payable on demand with interest payable monthly at the bank's current prime
rate (8.5% at June 30, 1998). The balance outstanding under this line as of June
30, 1998 was $2.7 million. Advances on the line of credit are collateralized by
a personal guarantee of the Company's majority shareholder. The Company used
proceeds from its July 1998 initial public offering to reduce the outstanding
balance by $1.3 million.
On July 27, 1998, the Company consummated an initial public offering (the
"offering") of 2,600,000 shares of its Common Stock at an initial public
offering price of $8.00 per share. During August 1998, BlueStone Capital
Partners, L.P. and Royce Investment Group, Inc. (collectively, the
"underwriters") exercised in full their overallotment option to purchase an
additional 390,000 shares of the Company's common stock at the initial public
offering price. All such shares were sold by the Company. The net proceeds to
the Company from the offering, including the net proceeds from exercise of the
underwriters' overallotment option, were approximately $21.3 million. Concurrent
with the closing of the offering, 82,634 shares of Series A Convertible
Preferred Stock and 132,744 shares of Series C Redeemable Convertible Preferred
Stock were converted into an equivalent number of shares of common stock, and
778,746 shares of Series B Convertible Preferred Stock were converted into
2,045,649 shares of common stock. The Company utilized $7.2 million in proceeds
from the offering to repay indebtedness as described in the Company's
Registration Statement on Form SB-2 declared effective on July 21, 1998. The
remaining proceeds received by the Company from such offering were invested in
short-term, investment-grade, interest-bearing instruments.
20
<PAGE>
The Company's future liquidity and capital requirements will depend upon
numerous factors, including the costs and timing of expansion of research and
product development efforts and the success of these efforts, the costs and
timing of expansion of sales and marketing activities, the extent to which the
Company's existing and new products gain market acceptance, competing
technological and market developments, the costs involved in maintaining and
enforcing patent claims and other intellectual property rights, available
borrowings under line of credit arrangements and other factors. Although the
Company anticipates, based on its proposed plans and assumptions relating to its
operations (including assumptions regarding the progress and timing of its new
product development efforts), that the net proceeds of the offering, together
with anticipated revenues from operations, availability under the Company's bank
lines of credit and cash and cash equivalents, will be sufficient to fund the
Company's operations and capital requirements for at least the next 12 months,
there can be no assurance that such funds will not be expended prior thereto due
to unanticipated changes in economic conditions or other unforeseen
circumstances. In the event the Company's plans change or its assumptions change
or prove to be inaccurate, the Company could be required to seek additional
financing sooner than currently anticipated. The Company has no current
arrangements with respect to, or potential sources of, any additional financing,
and it is not anticipated that existing shareholders will provide any portion of
the Company's future financing requirements. Consequently, there can be no
assurance that any additional financing will be available to the Company when
needed, on commercially reasonable terms, or at all. Any inability to obtain
additional financing when needed would require the Company to delay or scale
back its product development and marketing programs, which could have a material
adverse effect on the Company. In addition, any additional equity financing may
involve substantial dilution to the interests of the Company's then existing
shareholders.
The Company's forecast of the period of time through which its financial
resources will be adequate to support its operations is a forward-looking
statement that involves risks and uncertainties, and actual results could vary.
The factors described in the preceding paragraph, as well as other factors
described in Exhibit 99.01 hereto, will impact the Company's future capital
requirements and the adequacy of its available funds.
IMPACT OF ADOPTION OF NEW ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, "Reporting Comprehensive Income", which establishes standards for
reporting and presentation of comprehensive income. SFAS No. 130, which was
adopted by the Company in the first quarter of 1998, requires companies to
report a new measurement of income. "Comprehensive Income (Loss)" is to include
foreign currency translation gains and losses and other unrealized gains and
losses that have historically been excluded from net income (loss) and reflected
instead in equity. The Company's adoption of this standard did not have a
material effect on reported net loss or financial position for the periods
presented.
21
<PAGE>
In June 1997, FASB issued SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information", which establishes standards for disclosure
of segment information. SFAS No. 131 is effective for fiscal years beginning
after December 15, 1997 and will be adopted by the Company in the fourth quarter
of 1998. The Company does not believe that adoption of this standard will have a
material impact on the Company's financial position or results of operations.
In December 1997, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 97-2 which superseded SOP 91-1,
"Software Revenue Recognition". In addition, the AICPA issued SOP 98-4,
"Deferral of the Effective Date of a Provision of SOP 97-2, `Software Revenue
Recognition'". SOP 97-2 and SOP 98-4 are effective for fiscal years beginning
after December 15, 1997. The Company does not believe that adoption of these
standards will have a material impact on the Company's financial position or
results of operations.
YEAR 2000 ISSUE
Many currently installed computer systems and software products are coded
to accept only two digit entries in the date code field. These date code fields
will need to accept entries to distinguish 21st century dates from 20th century
dates. The inability to recognize or properly treat the Year 2000 may cause the
Company's systems and applications to process critical financial and operational
information incorrectly. The Company continues to assess the impact of the Year
2000 issue on its reporting system and operations. In addition, the Company is
assessing the readiness of its customers and suppliers for the Year 2000 issue;
however, there can be no assurance that these third parties will timely convert
their systems or that their systems will not have an adverse effect on the
Company. While uncertainty exists concerning the potential effects associated
with such compliance, the Company does not believe that Year 2000 compliance
will result in a material adverse effect on its financial condition or results
of operations.
22
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(a) Not applicable.
(b) Not applicable.
(c) On April 30, 1998, the Company issued 45,000 shares of Common Stock to
William Kaluza upon the exercise of outstanding options held by Mr.
Kaluza in reliance upon Rule 701 promulgated under the Securities Act
of 1933, as amended (the "Securities Act") as a transaction not
involving a public offering.
On May 12, 1998, the Company issued 48,604 shares of Common Stock to
Southeast Interactive Technology Fund I, L.L.C. pursuant to certain
anti-dilution rights pursuant to an agreement between the Company and
Southeast Interactive Technology Fund I, L.L.C. On May 21, 1998 the
Company issued 268,750 shares of Common Stock to J. W. Stealey upon the
exercise of outstanding options held by Mr. Stealey. Also on May 21,
1998, the Company issued 50,000 shares of Common Stock to Robert L.
Pickens upon the exercise of outstanding options held by Mr. Pickens.
Each of these sales was made in reliance upon Section 4(2) of the
Securities Act as a transaction not involving a public offering. Each
of the purchasers was a sophisticated investor.
From April 1, 1998 to June 30, 1998, the Company issued an aggregate of
230,935 incentive and performance incentive stock options to purchase
Common Stock pursuant to the Company's stock option plans to officers
and employees of the Company at a weighted average exercise price of
$6.00 per share. In the view of the Company, the options granted were
issued but not sold and, therefore, registration was not required.
(d) The Company's Registration Statement of Form SB-2 (Registration No.
333-53755) covering certain shares of its common stock was declared
effective on July 21, 1998. A total of 2,990,000 shares of the
Company's common stock, par value $0.10 per share, were registered
(including an over-allotment option for the sale of 390,000 shares).
The Company consummated an initial public offering of 2,600,000 shares
of common stock at a price to the public of $8.00 per share on July 27,
1998. The lead underwriters in the offering were BlueStone Capital
Partners, L.P. and Royce Investment Group, Inc.. During August 1998,
the underwriters exercised their right to purchase an additional
390,000 shares at the initial public offering price. The aggregate
offering price of the amount registered and sold was $23.9 million. The
total proceeds received by the Company, net of underwriting discounts
and estimated expenses of the offering, were approximately $21.3
million. The total underwriting discount was $1,674,000. Other expenses
in connection with the offering are estimated at $900,000. None of such
23
<PAGE>
underwriting discounts and expenses were paid, directly or indirectly,
to directors, officers or 10% stockholders of the Company or their
affiliates. Concurrent with the closing of the offering, 82,634 shares
of Series A Convertible Preferred Stock and 132,744 shares of Series C
Redeemable Convertible Preferred Stock were converted into an
equivalent number of shares of common stock, and 778,746 shares of
Series B Convertible Preferred Stock were converted into 2,045,649
shares of common stock. The remaining proceeds received by the Company
from such offering were invested in short-term, investment-grade,
interest-bearing instruments. Since the aforementioned offering was
consummated subsequent to the reporting period, refer to the Company's
Form SB-2 declared effective July 21, 1998 for the planned use of
proceeds.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company's predecessor held its Annual Meeting of stockholders on
May 26, 1998 (the "Annual Meeting"). At such meeting, the following directors
were elected: J.W. Stealey, David H. Kestel, J. Nicholas England, W. Joseph
McClelland and Avi Suriel. The following matters were submitted to stockholder
vote at the Annual Meeting:
(a) The election of the aforementioned Board of Directors of the
Company.
Votes For: 3,400,322
Votes Against: 0
Votes Abstaining: 3,888
(b) The approval and adoption of the Company's 1998 Stock Plan.
Votes For: 3,402,266
Votes Against: 1,620
Votes Abstaining: 324
(c) The approval and adoption of the Company's 1998 Employee Stock
Purchase Plan.
Votes For: 3,402,590
Votes Against: 1,620
Votes Abstaining: 0
(d) The approval of the Plan and Agreement of Merger to effect the
reincorporation and recapitalization of the Company in the State
of North Carolina by merging the Company's predecessor into a
wholly-owned North Carolina subsidiary corporation.
Votes For: 3,402,266
Votes Against: 1,620
Votes Abstaining: 324
(e) The ratification of the appointment of Ernst & Young LLP as
independent auditors for the Company for the fiscal year ending
December 31, 1998.
Votes For: 3,402,590
Votes Against: 1,620
Votes Abstaining: 0
ITEM 5. OTHER INFORMATION
Effective August 31, 1998, William H. Marks, the Company's chief
financial officer, secretary and treasurer, tendered his resignation to the
Company in order to pursue other business interests. Until a new chief financial
officer joins the Company, Robert L. Pickens, the Company's president, will
serve as the Company's chief financial officer.
24
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
EXHIBIT NO. DESCRIPTION OF EXHIBIT
---------- ----------------------
27.01 Financial Data Schedule
99.01 Risk Factors
(B) REPORTS ON FORM 8-K
There were no reports on form 8-K filed during the three months ended
June 30, 1998. During that period, the Company was not required to file reports
under the Exchange Act.
25
<PAGE>
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
INTERACTIVE MAGIC, INC.
September 4, 1998 By: /s/ J.W. Stealey
-------------------------------
J.W. Stealey
Chairman of the Board of Directors
and Chief Executive Officer
September 4, 1998 By: /s/ Robert L. Pickens
-------------------------------
Robert L. Pickens
President and Chief Operating Officer
(Principal Financial and Accounting Officer)
26
<PAGE>
EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION OF EXHIBIT
- ----------- -----------------------
27.01 Financial Data Schedule
99.01 Risk Factors
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEET OF INTERACTIVE MAGIC, INC. AS OF JUNE 30, 1998 AND
THE RELATED CONSOLIDATED STATEMENTS OF OPERATIONS AND CASH FLOWS FOR THE SIX
MONTH PERIOD ENDED JUNE 30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<NAME> INTERACTIVE MAGIC
<CIK> 0001061915
<MULTIPLIER> 1000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> JUN-30-1998
<CASH> 344
<SECURITIES> 0
<RECEIVABLES> 4,994
<ALLOWANCES> 0
<INVENTORY> 801
<CURRENT-ASSETS> 9,227
<PP&E> 1,092
<DEPRECIATION> 0
<TOTAL-ASSETS> 10,378
<CURRENT-LIABILITIES> 9,233
<BONDS> 0
600
86
<COMMON> 401
<OTHER-SE> (5,476)
<TOTAL-LIABILITY-AND-EQUITY> 10,378
<SALES> 8,735
<TOTAL-REVENUES> 8,735
<CGS> 1,572
<TOTAL-COSTS> 9,637
<OTHER-EXPENSES> 18
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 608
<INCOME-PRETAX> (1,528)
<INCOME-TAX> 128
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (1,656)
<EPS-PRIMARY> (0.46)
<EPS-DILUTED> 0
</TABLE>
<PAGE>
RISK FACTORS
Fluctuations in Quarterly Operating Results; Uncertainty of Future Results
The Company's quarterly operating results have fluctuated significantly in
the past and will likely fluctuate significantly in the future depending on a
variety of factors, several of which are not in the Company's control.
<PAGE>
Such factors include the demand for the Company's products and the products of
its competitors, the size and rate of growth of the interactive entertainment
software market, development and promotional expenses related to the
introduction of new products or enhancements, the degree of market acceptance
for the Company's new product introductions and enhancements, the timing of
orders from significant customers, delays in shipment, the level of price
competition, changes in computing platforms, the nature and magnitude of
product returns, order cancellations, software defects and other quality
problems, the length of product life cycles, the percentage of the Company's
sales related to international sales and changes in personnel. Products are
generally shipped as orders are received, and, accordingly, the Company
operates with little backlog. Net revenues in any quarter are, therefore,
substantially dependent on orders booked and shipped in that quarter. A
significant portion of the Company's operating expenses is relatively fixed,
and planned expenditures are primarily based on expectations regarding future
sales; as a result, operating results in any given quarter would be
disproportionately adversely affected by a decrease in sales or a failure to
meet the Company's sales expectations. Operating results for future periods are
subject to numerous uncertainties, and there can be no assurance that the
Company will become profitable or sustain profitability on an annual or
quarterly basis. Based on the foregoing, the Company believes that
period-to-period comparisons of operating results should not be relied upon as
indicative of future results.
Short CD-ROM Product Life Cycles; Dependence On a Limited Number of Products
The market for interactive CD-ROM software games is characterized by short
product life cycles and frequent introduction of new products, most of which do
not achieve sustained market acceptance or do not generate a sufficient level
of sales to offset the costs associated with product development. Generally,
the majority of sales of new products occur within the first six months
following their release. The Company's success will depend upon development of
new, commercially successful products and upon its ability to replace revenues
from products at the later stages of their life cycles. The Company believes
that competition in the interactive entertainment software market requires the
development of higher quality, distinctive products that incorporate
increasingly sophisticated effects and the need to support product releases
with increased marketing, all of which results in higher development,
acquisition and marketing costs. To date, the Company has derived a significant
portion of its revenues from a limited number of software products released
each year, and many of these products have substantial development or
acquisition costs and marketing budgets. Due to this dependence on a limited
number of products, the Company may be adversely affected if one or more of its
principal products fails to achieve anticipated results. During the years ended
December 31, 1996 and 1997, two titles and three titles accounted for
approximately 56.0% and 55.8%, respectively, of the Company's consolidated net
shipments after factoring in product returns. There can be no assurance that
the Company will not remain dependent upon non-recurring sales of a limited
number of products for a substantial portion of its revenues or that any
products introduced by the Company will be commercially viable or have life
cycles sufficient to permit the Company to recoup the development, marketing
and other costs associated with their development. Failure to continuously
introduce new, commercially successful products would have a material adverse
effect on the Company.
Lengthy Development Cycle; Product Development Risks
The Company's success depends on the timely introduction of successful new
products. The development of new interactive entertainment software products is
lengthy, expensive and uncertain, and a product's development typically
requires six to 24 months to complete from the time a new concept is approved.
In addition, product development of online products continues for the life of
the product. Many of the Company's proposed products are in early stages of
development, and the Company will be required to commit considerable time,
effort and resources to complete development of its currently proposed
products. The Company has, in the past, experienced significant delays in the
introduction of certain new products and there will likely be delays in
developing and introducing new products in the future. In addition, because
many of the Company's products are developed for it by third parties, the
Company cannot always control the timing of their introduction. While the
Company maintains production arrangements with its third-party developers,
provides them with certain software tool kits to promote quality control and
monitors their progress, there can be no assurance that delays in the work
performed by third parties or poor quality of such work will not result in
product delays. Unanticipated delays, expenses, technical problems or
difficulties could cause the Company to miss an important selling season with a
corresponding negative impact on revenues and net income or result in
abandonment or material change in product commercialization.
<PAGE>
There can be no assurance that the Company will be able to successfully develop
any new products on a timely basis or that technical or other problems will not
occur which would result in increased costs or material delays. In addition,
software products as complex as those offered by the Company may contain
undetected errors when first introduced. Despite extensive product testing, the
Company has, in the past, released products with defects and has discovered
software errors in certain of its product offerings after their introduction.
In particular, the personal computer hardware environment is characterized by a
wide variety of non-standard peripherals (such as sound cards and graphics
cards) and configurations that make pre-release testing for programming or
compatibility errors very difficult and time-consuming. There can be no
assurance that, despite testing by the Company, errors will not be found in new
products or releases after commencement of commercial shipments. Remedying such
errors may delay the Company's plans, cause it to incur additional costs and
adversely affect its reputation.
Industry Factors; Changing Consumer Preferences; Uncertainty of Market
Acceptance
The level of demand and market acceptance for the Company's newly
introduced products is subject to a high degree of uncertainty. Software
acquisition and development costs, as well as promotion and marketing expenses,
royalties and third-party participations payable to software developers,
creative personnel, musicians and others, which reduce potential revenues
derived from software sales, have increased significantly in recent years. The
Company's future operating results will depend on numerous factors beyond its
control, including the popularity, price and timing of new entertainment
software products being released and distributed, international, national,
regional and local economic conditions (particularly economic conditions
adversely affecting discretionary consumer spending), changes in consumer
demographics, the availability of other forms of entertainment, critical
reviews and public tastes and preferences, all of which change rapidly and
cannot be predicted. The Company's ability to plan for product development and
promotional activities will be significantly affected by its ability to
anticipate and respond to relatively rapid changes in consumer tastes and
preferences, particularly those of the consumers, primarily males over age 25
with annual household incomes of $50,000 or more, comprising the Company's
principal target market. A decline in the popularity of software games or in
the interactive entertainment software industry generally or in particular
market segments could adversely affect the Company's business and prospects. In
addition, the success of the Company's strategy to capitalize on online games
will depend in part upon market acceptance of online games and a "pay-for-play"
model. Online game play is a new and evolving concept, and it is difficult to
assess or predict with any assurance the size of the market for online games or
its prospects for growth. There can be no assurance that a viable market for
online games will develop, that the Company will be successful in developing
additional products for online use or that the Company's products for this
market will achieve widespread market acceptance.
Infrastructure Risks of Online Game Play
The development of a robust market for online games will depend on several
factors that are outside the Company's control, including the development and
maintenance of an industry infrastructure for providing consumer access to
online games. There can be no assurance that the infrastructure, including a
reliable network foundation, and timely development of complementary products,
such as high-speed modems, necessary to make local or wide area networks or the
Internet a viable medium for use of real-time large-scale multiplayer
simulation and strategy games will be developed, or, if developed, that such
networks will become a viable medium for use of multiplayer simulation and
strategy games. In addition, hardware restrictions, such as bandwidth (amount
of data capable of transmission at a single time) and latency (delays
introduced by the network), which limit use of content via local and wide area
networks, may inhibit such networks from becoming a viable medium for delivery
of multiplayer simulation and strategy games. If the necessary infrastructure
or complementary products are not developed, or if such networks do not become
a viable medium for delivery of multiplayer simulation and strategy games, the
Company's business, operating results and financial condition may be materially
adversely affected.
Changes in Technology and Industry Standards
The interactive entertainment software industry is undergoing rapid
changes, including evolving industry standards, frequent new platform
introductions and changes in consumer requirements and preferences. The
introduction of new technologies, technologies that support multiplayer games
and new media formats such as online delivery
<PAGE>
and digital video disks, could render the Company's previously released
products obsolete or unmarketable. The development cycle for products utilizing
new operating systems, microprocessors or formats may be significantly longer
than the Company's current development cycle for products on existing operating
systems, microprocessors and formats and may require the Company to invest
resources in products that may not become profitable. There can be no assurance
that the mix of the Company's future product offerings will keep pace with
technological changes or satisfy evolving consumer preferences or that the
Company will be successful in developing and marketing products for any future
operating system or format. Failure to develop and introduce new products and
product enhancements in a timely fashion could result in significant product
returns and inventory obsolescence and could have a material adverse effect on
the Company's business, operating results and financial condition.
The overall market for the Internet is characterized by rapidly changing
technology, evolving industry standards, emerging competition and frequent
product and service introductions. There can be no assurance that the Company
can successfully identify new product opportunities for Internet use and
develop and bring such new products to market in a timely manner, or that
products or technologies developed by others will not render the Company's
products or technology obsolete. The Company also is at risk to fundamental
changes in the way Internet connectivity services are delivered. Currently,
Internet services are accessed primarily by computers and are delivered by
telephone lines. If the Internet becomes accessible by screen-based telephones,
television or other consumer electronic devices, or becomes deliverable through
other means such as coaxial cable or wireless transmission, the Company may
have to develop new technology or modify its existing technology to accommodate
these developments. The Company's pursuit of such technological advances may
require substantial time and expense, and there can be no assurance that the
Company will succeed in adapting its products to alternate access devices and
conduits.
Intense Competition; Competition for Shelf Space
The interactive entertainment software industry is intensely and
increasingly competitive. Industry competition is based primarily upon product
quality and features, the compatibility of products with popular platforms,
access to distribution channels (including access to retail shelf space),
marketing effectiveness, reliability and ease of use, price and the quality of
user support services. Many of the companies with which the Company currently
competes or may compete against in the future have greater financial,
technical, marketing, sales and customer support and other resources than the
Company and have established reputations for success in the development,
licensing and sale of their products and technology. Current and future
competitors with greater financial resources than the Company may be able to
carry larger inventories, undertake more extensive marketing campaigns, adopt
more aggressive pricing policies and make higher offers or guarantees to third
party software developers and licensors than the Company. As competition
increases, significant price competition, increased production costs and
reduced profit margins may result. There can be no assurance that the Company
will be able to compete successfully against current or future competitors or
that competitive pressures faced by the Company will not have a material
adverse effect on its future operations.
Retailers of the Company's CD-ROM products typically have a limited amount
of shelf space and promotional resources, and there is intense competition
among entertainment software producers for adequate levels of desirable shelf
space and promotional support from retailers. As the number of entertainment
software products has increased, the competition for shelf space has
intensified, resulting in greater leverage for retailers and distributors in
negotiating terms of sale, including price discounts, marketing and display
fees and product return policies. The Company's CD-ROM products constitute a
relatively small percentage of any retailer's sales volume, and there can be no
assurance that retailers will continue to purchase the Company's products or
provide the Company's products with adequate levels of shelf space and
promotional support.
Ability to Manage and Sustain Growth; Risks Associated with Future Acquisitions
In addition to its internal growth strategies, the Company intends to
evaluate, on an ongoing basis, potential acquisitions of, or investments in,
other software publishers or developers, distributors or other businesses which
the Company believes will complement or enhance its existing business. The
success of such strategy thus will depend upon,
<PAGE>
among other things, the Company's ability to hire and retain skilled
management, marketing, technical and other personnel and to successfully manage
its growth (which also will require it to develop and improve upon its
operational, management and financial systems and controls in order to properly
monitor its expanded operations, control its costs and maintain effective
quality controls). There can be no assurance that the Company will be able to
expand its operations or that it will be able to effectively manage any such
expansion or anticipate and satisfy all of the changing demands and
requirements that growth will impose upon its operations. In addition,
acquisitions involve numerous additional risks, including difficulties in the
assimilation of the operations and products of the acquired companies, the
expenses incurred in connection with the acquisition and subsequent
assimilation of operations and products, the diversion of management's
attention from other business concerns and the potential loss of key employees
of the acquired company. Acquisitions of foreign companies also may involve the
additional risks of assimilating differences in foreign business practices and
overcoming language barriers. If the Company consummates any acquisition in the
future, there can be no assurance that the Company will be able to integrate
the acquired operations successfully, and any inability to do so could
adversely affect the Company's business.
Dependence on Third-Party Software Developers
The Company relies on third-party software developers for the development
of a significant number of its products. Due primarily to increased demand for
quality interactive entertainment software programs, the Company's payment of
advances and guaranteed royalties to such independent software developers has
increased and may continue to increase. There can be no assurance that the
sales of products associated with such royalties will be sufficient to cover
the amount of the Company's prepayment expenditures. Moreover, as independent
developers are in high demand, there can be no assurance that such developers,
including those that have developed products for the Company in the past, will
be available to develop products for the Company in the future. The failure to
obtain or renew product development agreements with such developers could have
a material adverse effect on the Company's future operations. In addition, many
independent developers have limited financial resources, which also could
expose the Company to the risk that such developers may go out of business
prior to completing a project.
Dependence on Third-Party Distribution Channels
The Company currently sells its CD-ROM software products primarily through
software distributors and to major computer and software retailing
organizations. Sales of CD-ROM games to a limited number of distributors and
retailers constitute a substantial majority of the Company's net revenues. For
the year ended December 31, 1996, sales of products to two distributors,
accounted for approximately 26.5% and 11.3%, respectively, of the Company's net
revenues. For the year ended December 31, 1997, sales of products to two
distributors accounted for 19.0% and 10.0% of the Company's net revenues,
respectively.
Certain mass market retailers have established exclusive buying
relationships under which such retailers will buy consumer software only from
one intermediary. In such instances, the price or other terms on which the
Company sells to such retailers may be adversely affected by the terms imposed
by such intermediary, or the Company may be unable to sell to such retailers on
terms which the Company deems acceptable. There can
<PAGE>
be no assurance that the Company's relationships with its current distributors
and retailers will continue or that the Company will be able to find other
means to market and distribute its CD-ROM products. The loss of, or a
significant reduction in sales attributable to, any of the Company's principal
distributors or retailers, in the absence of comparable new relationships or
the development of independent means of marketing and distributing its CD-ROM
games, could have a material adverse effect on the Company's revenues and
operating results. In addition, the Company maintains a reserve for
uncollectible receivables that it believes to be adequate, but the actual
reserve maintained may not be sufficient in every circumstance. A payment
default by a significant customer could have a material adverse effect on the
Company's business, operating results and financial condition. The Company also
intends to expand the distribution of its online products by seeking out
relationships with third-party providers of online or Internet services in the
United States and abroad. There can be no assurance that the Company will
successfully negotiate relationships with providers of online or Internet
services or, if completed, that such arrangements will generate significant
revenues. The Company could be materially adversely affected if the cost to the
Company of any proposed online or Internet distributor relationship exceeds
expectations or if the Company incurs significant costs in anticipation of the
arrangement and the arrangement is delayed or abandoned.
Risk of Product Returns
The Company accepts product returns or provides markdowns or other credits
in the event that customers hold excess inventory of the Company's products.
The Company also accepts returns of defective, damaged or shelf-worn products
at any time. At the time of product shipment, the Company establishes reserves
for stock-balancing, price protection and returns of defective, damaged and
shelf-worn products, based on historical return rates, retailer inventories of
the Company's products and other factors. Although the Company maintains
reserves which it believes to be adequate, if market acceptance is not
achieved, the Company could be forced to accept substantial product returns to
maintain favorable relationships with retailers and access to distribution
channels. There can be no assurance that actual returns to the Company will not
exceed the reserves established. Product returns that exceed the Company's
reserves could materially and adversely affect the Company's operating results.
Dependence on Key Personnel
The Company's success depends to a significant extent on the performance
and continued service of its senior management and certain key employees.
Competition for highly skilled employees with technical, management, marketing,
sales, product development and other specialized training is intense, and there
can be no assurance that the Company will be successful in attracting or
retaining such personnel. Specifically, the Company may experience increased
costs in order to attract and retain skilled employees. Although the Company
generally enters into term employment agreements with its senior management,
there can be no assurance that such employees or any other employees will not
leave the Company or compete against the Company. The Company's failure to
attract or retain qualified employees could have a material adverse effect on
the Company's business, operating results and financial condition.
Limited Protection of Proprietary Information
The Company regards its software technology as proprietary and holds
copyrights on its internally developed products, manuals, advertising and other
materials and maintains trademark rights in the Company name, the Interactive
Magic logo and the names of products owned by the Company. The Company does not
acquire the copyrights for works developed by third parties under license which
the Company publishes. Although the Company has applied for a patent on its
MEGAplayer technology that enables its online products to function more
effectively on the Internet, there can be no assurance that a patent will be
issued by the United States Patent and Trademark Office. While the Company
relies on a combination of trademark, trade secret, copyright and other
proprietary rights laws, license agreements, employee and third-party
non-disclosure agreements and other methods to establish and protect its
proprietary rights, there can be no assurance that the steps taken by the
Company will be adequate to prevent misappropriation of the technology or
independent development by others of software products with features based
upon, or otherwise similar to, those of the Company's products. To license its
products to end users, the Company primarily relies on "shrink wrap" licenses
that are not signed by the end-user and, therefore, may be unenforceable under
the laws of certain jurisdictions. In addition, effective copyright and trade
secret
<PAGE>
protection may be unavailable or limited in certain foreign countries, and the
global nature of certain wide area networks, particularly the Internet, makes
it virtually impossible to control the ultimate destination of the Company's
products. Despite the Company's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy aspects of the Company's products or
to obtain and use information that the Company regards as proprietary.
Unauthorized copying is common within the software industry, and if a
significant amount of unauthorized copying of the Company's products were to
occur, the Company's business, operating results and financial condition could
be adversely affected. As the number of software products in the industry
increases and the functionality of these products further overlaps, software
developers may become increasingly subject to infringement claims. There can be
no assurance that third parties will not assert infringement claims against the
Company in the future with respect to current or future products. As is common
in the industry, from time to time, the Company receives notices from third
parties claiming infringement of intellectual property rights of such parties.
The Company investigates these claims and responds as it deems appropriate.
Litigation may be necessary in the future to enforce the Company's intellectual
property rights, to protect the Company's trade secrets, to determine the
validity and scope of the proprietary rights of others, or to defend against
claims of infringement or invalidity. Any such litigation could result in
substantial costs and diversion of resources and could have a material adverse
effect on the Company.
Risks Related to International Revenues and Operations
The Company distributes its products in over 30 countries worldwide and
maintains sales offices in the United Kingdom and Germany in addition to its
facilities and operations in the United States. International sales and
licensing (excluding online revenue) accounted for 23% and 37% of the Company's
net revenues in 1996 and 1997, respectively. International operations and sales
of CD-ROM products are subject to inherent risks, including fluctuations in
exchange rates, the impact of possible recessionary environments in economies
outside the United States, the costs of transferring and localizing products
for foreign markets, longer accounts receivable collection periods and
difficulty in collection of accounts receivable, unexpected changes in
regulatory requirements, tariffs and other barriers, difficulties and costs of
staffing and managing foreign offices and potential political and economic
instability. Revenues and expenses from the Company's foreign operations
generally are denominated in local currencies, and, as a result, exchange rate
fluctuations between such local currencies and the U.S. dollar will subject the
Company to currency translation risk from the reported results of its foreign
operations. The Company intends to continue to expand its direct and indirect
sales and marketing activities worldwide; however, there can be no assurance
that the Company will be able to maintain or increase international market
demand for its products or that these or other factors will not have a material
adverse effect on the Company's future international sales and, consequently,
on the Company's operating results.
Manufacturing Risks
The production of the Company's published products for retail sale
involves duplicating software programs onto CD-ROM disks, printing user manuals
and product packaging materials and packaging finished products. The foregoing
activities are performed for the Company by third-party vendors in accordance
with the Company's specifications. While these services are available from
multiple parties and at multiple sites, there can be no assurance that an
interruption in the manufacture of the Company's products will not occur and,
if it does occur, that it could be remedied without undue delay. In addition,
the Company must compete for CD-ROM duplication services with its competitors,
as well as publishers of music and video CDs. While the Company engages in
ongoing efforts to ensure an adequate and timely supply of CD-ROMs, there can
be no assurance that the future supply of CD-ROMs will be sufficient to meet
the Company's requirements. The Company must place advance orders for finished
goods based on forecasts of the sales volume of the product; there can be no
assurance that the Company's forecasts will prove accurate, and any resulting
over-production or under-production of the Company's CD-ROM products could have
a material adverse effect on the Company.
Outstanding Indebtedness; Consequences of Default and Covenants Under Lines of
Credit
<PAGE>
The Company's ability to meet its debt service obligations will depend on
the Company's future operations, which are subject to prevailing industry
conditions and other factors, many of which are beyond the Company's control.
Because indebtedness under the Company's lines of credit bear interest at rates
that fluctuate with prevailing interest rates, increases in such prevailing
rates would increase the Company's interest payment obligations and could
adversely affect the Company's financial condition and results of operations.
Furthermore, the Company's indebtedness under its $5,000,000 line of credit is
secured by substantially all of the Company's assets, as well as the assets of
its wholly-owned subsidiary, iMagic Online Corporation. In the event of a
violation by the Company of any of its loan covenants or any other default by
the Company on its obligations relating to its indebtedness, the lender could
declare such indebtedness to be immediately due and payable and, in certain
cases, the lender could then foreclose on the pledged collateral. Although the
Company expects that it will be in compliance with all of its loan covenants
upon the consummation of this offering, there can be no assurance that the
Company will be able to maintain such compliance in the future. A default
relating to the Company's indebtedness, in the absence of a waiver, could have a
material adverse effect upon the Company's business and financial condition.
Moreover, to the extent that the accounts receivable, inventory and intellectual
property of the Company (excluding its foreign subsidiaries) continue to be
pledged to secure its outstanding indebtedness under the credit facility, such
assets will not be available to secure additional indebtedness, which may affect
the Company's ability to borrow in the future.
<PAGE>
Dividends
The Company has never paid any cash dividends on its Common Stock and does
not anticipate paying cash dividends in the foreseeable future as it intends to
retain any net income for use in connection with the expansion of its business.
Year 2000 Compliance
Many currently installed computer systems and software products are coded
to accept only two digit entries in the date code field. These date code fields
will need to accept entries to distinguish 21st century dates from 20th century
dates. As a result, in less than two years, computer systems and software used
by many companies may need to be upgraded to comply with such Year 2000
requirements. The Company believes that its products, which are self-contained
software programs that run independently of external systems, will not be
significantly affected by Year 2000 issues. The Company is currently in the
process of investigating whether its internal accounting systems and other
operational systems will be affected by the Year 2000 issue. In addition, the
Company is assessing the readiness of third-party customers and suppliers for
the Year 2000 issue. There can be no assurance that these third parties will
timely convert their systems or that their systems will not have an adverse
effect on the Company, or that Year 2000 issues or the cost of addressing them
will not have a material impact on the Company's financial statements, business
or operations.
