<PAGE> 1
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------
FORM 10-Q/A
(AMENDMENT NO. 1)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
--- EXCHANGE ACT OF 1934 for Quarterly period ended December 31, 1995
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
--- AND EXCHANGE ACT OF 1934 for the Quarterly period from _____ to _____.
Commission file number: 0-17154
SIERRA ON-LINE, INC.
-----------------------------------------------------
(Exact name of Registrant as specified in its charter)
DELAWARE 77-0164293
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(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)
3380 - 146TH PLACE SE., SUITE 300, BELLEVUE, WA 98007
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(Address of principal executive offices) (Zip)
(206) 649-9800
----------------------------------------------------
(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
--- ---
The number of shares of the Registrant's common stock outstanding as of January
31, 1996 was 20,003,982
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SIERRA ON-LINE, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets at December 31, 1995
and March 31, 1995 ................................................ 3
Consolidated Statements of Operations --
three and nine months ended December 31, 1995 and 1994 ............ 4
Consolidated Statements of Cash Flows --
nine months ended December 31, 1995 and 1994 ...................... 5
Notes to Consolidated Financial Statements --
nine months ended December 31, 1995 and 1994 ...................... 6
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations ..................... 8
PART II. OTHER INFORMATION
Item 5. Other Information ................................................. 10
Item 6. Exhibits and Reports of Form 8-K .................................. 30
SIGNATURES .......................................................................... 31
</TABLE>
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PART I
FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
SIERRA ON-LINE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
December 31, March 31,
1995 1995
-------- --------
<S> <C> <C>
ASSETS (Unaudited)
CURRENT ASSETS:
Cash and cash equivalents ........................................................... $ 34,861 $ 50,186
Marketable investment securities .................................................... 50,196 50,573
Accounts receivable, net of allowances of $15,988 and $7,265 ........................ 56,809 12,984
Inventories ......................................................................... 7,081 4,903
Deferred income taxes ............................................................... 4,166 1,777
Refundable income taxes ............................................................. --- 670
Other current assets (including $792 receivable from related parties on March 31) ... 4,510 4,262
-------- --------
Total Current Assets ............................................................ 157,623 125,355
PROPERTY, PLANT AND EQUIPMENT, net ....................................................... 11,522 9,068
SOFTWARE DEVELOPMENT COSTS ............................................................... 263 1,048
GOODWILL, net of accumulated amortization of $4,026 and $2,871 ........................... 9,728 6,498
DEFERRED INCOME TAXES .................................................................... 1,559 1,522
OTHER ASSETS ............................................................................. 1,461 1,863
-------- --------
$182,156 $145,354
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable .................................................................... $ 16,042 $ 6,127
Accrued compensation and related benefits ........................................... 4,799 4,118
Accrued incentive payments .......................................................... --- 1,562
Notes payable (including $2,430 payable to related parties on December 31) .......... 3,301 384
Royalties payable (including $429 and $633 payable to a related party) .............. 4,647 2,938
Deferred revenue .................................................................... 2,789 1,261
Accrued interest .................................................................... 405 1,160
Income taxes payable ................................................................ 6,891 308
Other accrued expenses (including $247 payable to related parties on March 31) ...... 4,764 4,336
-------- --------
Total Current Liabilities ....................................................... 43,638 22,194
ADVANCES UNDER PUBLISHING AGREEMENT AND OTHER LIABILITIES ................................ 1,010 5,907
CONVERTIBLE DEBT, net of unamortized discount and issuance costs of $615 and $1,066 ...... 23,360 34,634
MINORITY INTEREST IN SIERRA PIONEER JOINT VENTURE ........................................ 1,295 ---
STOCKHOLDERS' EQUITY:
Preferred stock, par value of $.01 per share;
1,000,000 shares authorized; none outstanding ................................... --- ---
Common stock and paid in capital, par value $.01 per share;
40,000,000 shares authorized; 20,072,317 and 18,726,519 shares
issued as of December 31, 1995 and March 31, 1995, respectively ................. 86,492 70,052
Retained earnings, including net unrealized holding gain ............................ 27,147 12,797
Cumulative translation adjustment ................................................... (437) 119
-------- --------
113,202 82,968
Less common stock in treasury, 94,154 shares, at cost ............................... 349 349
-------- --------
Total Stockholders' Equity ................................................. 112,853 82,619
-------- --------
$182,156 $145,354
======== ========
</TABLE>
See Notes to Consolidated Financial Statements.
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SIERRA ON-LINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
Three months ended Nine months ended
December 31, December 31 ,
---------------------- -----------------------
1995 1994 1995 1994
---------------------- -------- -------
<S> <C> <C> <C> <C>
REVENUES:
Net sales .................................... $62,702 $41,126 $120,953 $74,334
Other ........................................ 518 87 1,661 1,395
------- ------- -------- -------
63,220 41,213 122,614 75,729
------- ------- -------- -------
OPERATING EXPENSES:
Manufacturing costs .......................... 11,915 8,310 24,668 16,242
Amortization of software development costs ... 285 5,195 785 9,183
Royalties .................................... 5,452 2,835 9,713 5,698
Selling, general and administrative .......... 18,583 10,581 37,439 25,157
Research and development ..................... 9,771 6,105 26,816 15,625
------- ------- -------- -------
46,006 33,026 99,421 71,905
------- ------- -------- -------
INCOME FROM OPERATIONS ............................ 17,214 8,187 23,193 3,824
------- ------- -------- -------
OTHER INCOME (EXPENSE):
Gain on sale of The ImagiNation Network ...... --- 19,739 --- 19,739
Equity in loss from The ImagiNation Network .. --- --- --- (1,990)
Shareholder litigation costs ................. --- (1,500) --- (1,500)
Interest expense ............................. (365) (2,670) (2,334) (3,575)
Interest income .............................. 1,175 890 3,972 2,310
Amortization of goodwill ..................... (475) (301) (1,376) (905)
------- ------- -------- -------
(335) 16,158 (262) 14,079
------- ------- -------- -------
INCOME BEFORE INCOME TAXES ........................ 17,549 24,345 23,455 17,903
INCOME TAXES:
Income tax provision ......................... 6,210 6,549 7,925 5,631
Change in valuation allowance ................ (945) --- (1,215) ---
------- ------- -------- -------
NET INCOME ........................................ $12,284 $17,796 $ 16,745 $12,272
======= ======= ======== =======
NET INCOME PER SHARE:
Primary ...................................... $ 0.58 $ 0.97 $ 0.80 $ 0.68
Fully diluted ................................ $ 0.55 $ 0.83 $ 0.77 $ 0.63
Weighted average shares outstanding:
Primary ...................................... 21,298 18,417 20,873 18,170
Fully diluted ................................ 23,011 22,221 22,865 22,130
</TABLE>
See Notes to Consolidated Financial Statements.
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SIERRA ON-LINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
Nine months ended
December 31,
-----------------------
1995 1994
-------- --------
<S> <C> <C>
OPERATING ACTIVITIES:
Net income (loss) .............................................................. $ 16,745 $ 12,272
Reconciliation to net cash provided by (used for) operating activities:
Depreciation and leasehold amortization ............................... 3,148 2,883
Amortization of intangible assets and issuance costs .................. 2,161 10,551
Gain on sale of The ImagiNation Network ............................... --- (19,739)
Loss from The ImagiNation Network ..................................... --- 1,990
Loss from Sierra Pioneer Joint Venture ................................ 262 ---
Provision for doubtful accounts ....................................... 1,472 774
Deferred income taxes ................................................. (2,424) (7,200)
Other ................................................................. (472) 364
Cash provided (used) by changes in assets and liabilities:
Accounts receivable .............................................. (45,297) (12,717)
Inventories .................................................................... (2,178) (758)
Other current assets ........................................................... (2,946) (915)
Software development costs ....................................... --- (5,037)
Other assets ..................................................... (4,100) (1,023)
Accounts payable ................................................. 9,915 2,402
Royalties payable ................................................ 1,710 1,680
Deferred revenue ................................................. 1,528 5,975
Other accrued expenses ........................................... 3,269 5,741
Income taxes refundable/payable .................................. 8,534 13,523
Advances under publishing agreement and other liabilities ........ (2,199) 1,093
-------- --------
Net cash provided (used) by operating activities ...................... (10,872) 11,859
INVESTING ACTIVITIES:
Proceeds from sale of The ImagiNation Network ............................. --- 19,739
Proceeds from matured or retired marketable investment securities ......... 74,154 35,442
Purchase of marketable investment securities .............................. (73,777) (40,216)
Net purchase of property, plant, and equipment ............................ (5,566) (3,070)
Loan to The ImagiNation Network ........................................... --- (2,895)
Incentive payments to subsidiaries ........................................ (1,562) (1,620)
Investment in Sierra Pioneer Joint Venture ................................ (1,493) ---
-------- --------
Net cash used by investing activities ................................ (8,244) 7,380
FINANCING ACTIVITIES:
Net proceeds from convertible note offering ............................... --- 48,250
Proceeds from exercise of options and warrants ............................ 3,780 1,806
Principal payment on note borrowings and lease obligations ................ --- 55
-------- --------
Net cash provided by financing activities ............................. 3,780 50,111
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ........................... (15,336) 69,350
EFFECT OF EXCHANGE RATE CHANGES ON CASH ........................................ 11 (44)
CASH AND CASH EQUIVALENTS:
BEGINNING OF YEAR ......................................................... 50,186 3,281
-------- --------
END OF PERIOD ............................................................. $ 34,861 $ 72,587
======== ========
</TABLE>
See Notes to Consolidated Financial Statements.
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<PAGE> 6
SIERRA ON-LINE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NINE MONTHS ENDED DECEMBER 31, 1995 AND 1994
NOTE 1 - BASIS OF PRESENTATION AND ACCOUNTING POLICIES
The accompanying financial statements of Sierra On-Line, Inc. (the
"Company") should be read in conjunction with Item 5 in this Form 10-Q. The
financial statements included in Item 5 of the Company's Form 10-Q for the three
months ended June 30, 1995, and in the Company's Form 10-K for the year ended
March 31, 1995, and the related management discussion and analysis, have been
superseded by the financial information included in Item 5 of this Form 10-Q.
The unaudited interim financial information, as of and for the periods
ended December 31, 1995 and 1994 was prepared in a manner consistent with the
audited financial statements and pursuant to the rules and regulations of the
Securities and Exchange Commission. In the opinion of management, the
accompanying interim financial statements reflect all adjustments which are of a
normal recurring nature and necessary to present fairly the financial position,
results of operations and cash flows for the periods presented. The results of
operations for the three and nine months ended December 31, 1995 are not
necessarily indicative of the results to be expected for the entire year.
NOTE 2 - BUSINESS COMBINATIONS
On May 31, 1995 the Company merged with The Pixellite Group
("Pixellite"), a developer of personal printing software, in exchange for
245,779 shares of Sierra's Common Stock. On June 20, 1995 the Company also
merged with Software Inspiration, Ltd. ("Inspiration"), a developer of strategy
games, in exchange for 730,352 shares of Sierra's Common Stock.
In July the Company merged with Green Thumb Software and in September
merged with Arion Software in exchange for 87,762 and 60,196 shares of Sierra
Common Stock, respectively. Green Thumb is a developer of landscape design
products and Arion is a developer of cooking software.
On November 30, 1995 the Company merged with Papyrus Design Group
("Papyrus"), developers of NASCAR Racing and Indy Car Racing, in exchange for
approximately 1.2 million shares of Sierra's Common Stock.
These mergers have been accounted for as poolings-of-interests. The
pooling-of-interests method of accounting is intended to present as a single
interest two or more common shareholders' interests which were previously
independent; accordingly, the unaudited financial information presented herein
reflects the combined results of Sierra, Pixellite, Inspiration and Papyrus for
all periods presented.
The financial statements have not been restated for the Green Thumb and
Arion mergers as these companies did not impact the Company's operations
significantly.
All fees and expenses related to the mergers described above have been
expensed as required under the pooling-of-interest accounting method. These
expenses have been reflected in the consolidated statement of operations of the
Company for the three and nine months ended December 31, 1995. Such fees and
expenses total approximately $1.3 million, and $1.7 million, respectively, for
the three and nine month periods, and include legal, accounting and finders
fees.
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The following summarizes amounts previously reported by Sierra prior to
the transaction for the three and nine months ended December 31, 1994 (in
thousands, except per share data):
Three months ended December 31, 1994:
<TABLE>
<CAPTION>
Net Income
(Primary Earnings)
Revenues Net Income Per Share
-------- ---------- ---------
<S> <C> <C> <C>
Sierra ............................... $35,117 $16,548 $1.03
Pixellite, Inspiration and Papyrus ... 6,096 1,248 (0.06)
------- ------- -----
Combined ............................. $41,213 $17,796 $0.97
======= ======= =====
</TABLE>
Nine months ended December 31, 1994:
<TABLE>
<CAPTION>
Net Income
(Primary Earnings)
Revenues Net Income Per Share
-------- ---------- ---------
<S> <C> <C> <C>
Sierra ............................... $65,170 $11,676 $0.74
Pixellite, Inspiration and Papyrus ... 10,559 596 (0.06)
------- ------- -----
Combined ............................. $75,729 $12,272 $0.68
======= ======= =====
</TABLE>
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NOTE 3 - JOINT VENTURE
In July 1995 the Company entered into a joint venture agreement with
Pioneer Electronic Corporation ("Pioneer") to market and develop entertainment
and other software titles for the Japanese market. Under this agreement Sierra
On-Line received 51% ownership of the Sierra Pioneer Joint Venture in exchange
for a capital contribution of approximately $1.5 million. Sierra On-Line also
agreed to contribute up to an additional $3.7 million, or 367 million yen, in
additional capital in proportion to its 51% ownership interest, subject to
certain conditions. The Company also licensed to the joint venture the right to
publish and distribute in Japan and Asia all of the Company's software products
in exchange for quarterly royalty payments. The results of operations and
financial position of the Sierra Pioneer Joint Venture are consolidated with the
financial statements of Sierra On-Line.
NOTE 4 - NET INCOME (LOSS) PER SHARE
Net income (loss) per share is based upon the weighted average number
of common shares outstanding during the period as adjusted for the shares issued
in the mergers described in Note 2 and after consideration of the dilutive
effect, if any, of stock options granted using the treasury stock method. In
addition, conversion of the Company's 6-1/2% Convertible Subordinated Notes are
included in fully diluted income per share using the if-converted method when
such securities are dilutive.
NOTE 5 - INVENTORIES
<TABLE>
<CAPTION>
Inventories consist of the following: (Dollars in thousands)
December 31, March 31,
1995 1995
------ ------
<S> <C> <C>
Raw materials ............... $4,127 $2,841
Work in progress ............ --- 65
Finished goods .............. 2,954 1,997
------ ------
$7,081 $4,903
====== ======
</TABLE>
NOTE 6 - FEDERAL INCOME TAXES - CHANGE IN VALUATION ALLOWANCE
The valuation allowance was decreased $945,000 during the three months
ended December 31, 1995 and $1,215,000 during the nine months ended December 31,
1995 as the result of the Company being able to utilize previously allowanced
credits.
NOTE 7 - NEW ACCOUNTING POLICIES
In October 1995, the Financial Accounting Standards Board issued
Statement No. 123, Accounting for Stock-Based Compensation. This pronouncement
establishes the accounting and reporting standards for stock-based employee
compensation plans, including: stock purchase plans, stock options, and stock
appreciation rights. This new standard defines a fair value-based method of
accounting for these equity instruments. This method measures compensation cost
based on the value of the award and recognizes that cost over the service
period. Companies may elect to adopt this standard or to continue accounting for
these types of equity instrument under current guidance, APB Opinion No. 25,
Accounting for Stock Issued to Employees. Companies which elect to continue
using the rules of Opinion 25 must make pro forma disclosures of net income and
earnings per share as if this new statement had been applied. This new standard
is required for fiscal years beginning after December 15, 1995.
The Company is in the process of evaluating this statement and its
impact on the Company's financial condition and results of operations.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This management's discussion and analysis and the accompanying
financial statements should be read in conjunction with Item 5 in this Form
10-Q. The financial statements included in Item 5 of the Company's Form 10-Q for
the three months ended June 30, 1995, and in the Company's Form 10-K for the
year ended March 31, 1995, and the related management discussion and analysis,
have been superseded by the financial information included in Item 5 of this
Form 10-Q.
On May 31, 1995 the Company merged with Pixellite, a developer of
personal printing software, in exchange for 245,779 shares of Sierra's Common
Stock. On June 20, 1995 the Company also merged with Inspiration, a developer of
strategy games, in exchange for 730,352 shares of Sierra's Common Stock. In July
1995 the Company merged with Green Thumb Software and in September 1995 merged
with Arion Software in exchange for 87,762 and 60,196 shares of Sierra Common
Stock, respectively. Green Thumb is a developer of landscape design products and
Arion is a developer of cooking software. On November 30, 1995 the Company
merged with Papyrus, developers of NASCAR Racing and Indy Car Racing, in
exchange for approximately 1.2 million shares of Sierra's Common Stock.
These mergers have been accounted for as poolings-of-interests. The
pooling-of-interests method of accounting is intended to present as a single
interest two or more common shareholders' interests which were previously
independent; accordingly, the financial information presented herein reflects
the combined results of Sierra, Pixellite, Inspiration and Papyrus for all
periods presented. The financial statements have not been restated for the Green
Thumb and Arion mergers as these companies did not impact the Company's
operations significantly.
OVERVIEW
The Company is a leading publisher and distributor of interactive
entertainment, education and personal productivity software titles for
multimedia personal computers ("PCs"), including CD-ROM-based PC systems, and
selected emerging platforms. The multimedia PC consumer software market has
grown dramatically in recent years, driven by the increasing installed base of
multimedia PCs in the home, the proliferation of new software titles and new and
expanding distribution channels. These factors have led to the development of a
mass market for software products, which has been characterized by a rise in
importance of strong distribution channels, a significant increase in the number
of new software titles offered in the market, increased competition for limited
retail shelf space to accomodate the abundance of new titles, and increased
price pressure. Consumer reaction to different software titles is often
unpredictable. Certain titles may gain broad popularity while others may not be
received well in the market. Generally, entertainment and education software
producers differentiate themselves by their ability to design products that are
fun and/or educational, while at the same time exploiting the graphics, image,
animation, audio and video capabilities of various hardware platforms. According
to industry sources, the size of the overall market for consumer software was
estimated at $4.6 billion in 1994 and $5.8 billion in 1995 and is estimated to
increase to $10 billion in 1999. Entertainment and education software is
estimated to represent approximately 50 to 55% of the total consumer PC software
market. This growth has been fueled by increasing sales of PCs to consumers,
which are estimated to reach over 15 million in 1999 from 9.5 million in 1995.
The Company derives its revenues primarily from the sale of
entertainment and education software products. Substantially all of the
Company's net sales, ninety-five percent in fiscal 1995, represent products sold
primarily through large computer superstores, software specialty retail chains,
wholesale clubs, and mass merchandisers. The remainder represents income from
licensing of software products for software bundling arrangements. Other
revenues consist of income from the Company's 900 telephone number hintline and
advertising revenue from the Company's INTERAction! magazine. Although no one
single customer accounted for over ten percent of gross revenues in fiscal years
1995 and 1994, the Company estimates that its top ten customers accounted for
approximately 44% of revenues in fiscal 1994 and 40% of revenues in fiscal 1995.
Sales arrangements with retailers and mass merchandisers permit them to
exchange products or receive price protection under certain circumstances. Net
sales reflects allowances for estimated returns and exchanges and price
protection. During the nine months ended December 31, 1995, the Company
increased direct distribution sales to superstores and wholesale clubs and
experienced an increase in average price per unit through a movement in
technology platform from disk-based to CD-ROM-based sales. These changes have
led to a disproportionate increase in the reserve for sales returns and
allowances, included in accounts receivable, relative to net sales.
A majority of product development is done internally through employees
and independent contractors. The Company's average cost for developing a product
has continued to increase substantially each year due to the greater number of
more technologically sophisticated products being developed simultaneously. In
addition, the increasing technological sophistication of the Company's products
has resulted in increased product development costs and increased the likelihood
of product release delays. The Company has been unable to pass along these
increased development costs by way of price increases due to increasing
competition. In prior periods, the Company has been able to mitigate the adverse
impact of increased development costs on
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operating profit through increased unit sales and improved manufacturing
margins. There can be no assurances, however, that the Company will be able to
continue to do so in future periods.
The Company estimates that product life cycles for entertainment
software products are continuing to decrease. Education software continues to
have a somewhat longer shelf life. Due to the compression of product life
cycles, increasing competition, and the increasing technological sophistication
of its products, the Company has focused its development resources on fewer
titles. This has increased the risk of revenue volatility which the Company is
seeking to minimize through a broadening of its product offerings into home
productivity and other categories.
The Company typically owns all rights to contributions to products by
independent contractors under license or assignment agreements requiring the
payment of royalties by the Company. Aggregate royalty rates on the Company's
current principal products generally range from approximately 1% to 20% of gross
revenue derived from the product, less certain associated costs. As the Company
develops more complex multimedia products, such as CD-ROM-based products, it
anticipates that royalty costs will increase as a percentage of net sales.
The Company's revenues and earnings are highly seasonal due to
traditional consumer buying habits. The Company expects the historical trend of
realizing its highest revenues and earnings during the holiday shopping season
in the quarter ended December 31 and its seasonal lows in revenues and earnings
in the quarter ended June 30 to continue. The Company's quarterly operating
results may fluctuate throughout the year as a result of a variety of additional
factors, including delays in market acceptance, changes in platform standards,
the timing of the introduction of the Company's or its competitors' products,
the timing of orders for the Company's products and increases in product
returns. Because a majority of the unit sales for a particular product typically
occurs in the first several months after the product is introduced, the
Company's revenues may increase in a quarter in which a major product
introduction occurs and may decline in following quarters. The Company's
expenses are based, in part, on expected future revenues. A significant amount
of the Company's marketing, administrative, design and development expenses do
not vary in relation to revenues. As a result, if net revenues are below
expectations, the Company's operating results are likely to be materially and
adversely affected. During any given fiscal year, a substantial proportion of
the Company's gross sales is generated from titles introduced during that fiscal
year. Over the next several years, the Company expects that an increasing
portion of its revenues will come from sales of simulation, action and
educational products, as well as new product lines. The Company believes that
the impact of inflation and changing prices has not had a significant impact on
income.
The entertainment and education software industry is intensely
competitive. Products in the market compete primarily on the basis of subjective
factors such as entertainment value and objective factors such as price,
graphics and sound quality. Large diversified entertainment, cable and
telecommunications companies, in addition to large software companies such as
Microsoft Corporation, are increasing their focus on the interactive
entertainment and education software market, which will result in even greater
competition for the Company. Many of these companies have substantially greater
financial, marketing and technical resources than the Company. As competition
increases, significant price competition and reduced profit margins may result.
In response to increased competition for shelf space, the Company may need to
increase marketing expenditures. In addition, competition from new technologies
(such as new hardware platforms) may reduce demand in markets in which the
Company has traditionally competed. Prolonged price competition or reduced
demand as a result of competing technologies would have a material adverse
effect on the Company's business, financial condition and operating results.
The Company generates revenues from customers throughout the world,
maintains sales and representative offices in its major foreign markets and
holds certain deposits and accounts in foreign currencies. The majority of the
Company's foreign operations are conducted by its France and United Kingdom
subsidiaries in French Francs (the Franc) and British Pound Sterling (the
Pound). Foreign revenues, expenses, currency and other accounts can be affected
by foreign currency fluctuations. Revenues generally exceed expenses and assets
exceed liabilities in non-U.S. currencies.
RESULTS OF OPERATIONS
THREE MONTHS ENDED DECEMBER 31, 1995 AND 1994
REVENUES: Net sales of $62,702,000 and total revenues of $63,220,000
for the current quarter represented increases of 52% and 53%, respectively,
compared to the same quarter in the prior year. International revenues increased
$8.9 million or approximately 86% over the $10.4 million in international
revenues for the comparable quarter of the prior year. For the three months
ended December 31, 1995 as compared to the three months ended December 31, 1994
there was a weakening of the U.S. dollar in Europe which had the effect of
increasing the dollar value of net revenues denominated in non-U.S. currencies.
The Company estimates that the weakening of the U.S. dollar accounted for
approximately $1.6 million of the increase in the Company's consolidated net
revenues for the three months ended December 31, 1995.
Due to the historically seasonal nature of the Company's business, the
quarter ending December 31, which includes the holiday shopping season,
typically has the highest sales volume of any fiscal quarter. In addition to
seasonality, consumer perception
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<PAGE> 11
of the general economy, competition for retail shelf space, and the success of
the Company's most recent product releases, among other factors, can have major
impacts on sales volume.
For the quarter ended December 31, 1995, 47% of net sales was derived
from products released in the current quarter and 75% were from titles released
in the preceding 12 months. In the comparable prior year quarter, 64% of net
sales was derived from current quarter releases and 85% was from titles released
in the prior 12 months.
The following table sets forth the percentage of the Company's net
sales derived from software product categories for the two quarters indicated:
<TABLE>
<CAPTION>
Quarter Ended December 31,
--------------------------
1995 1994
----------- -----------
<S> <C> <C>
Category:
Adventure ............. 43% 37%
Simulation ............ 11% 26%
Educational ........... 15% 9%
Action/Family ......... 12% 6%
Sports ................ 18% 21%
Other ................. 1% 1%
----------- -----------
100% 100%
=========== ===========
Net Sales ............... $62,702,000 $41,126,000
</TABLE>
The provision for customer returns and price protection reduced sales
by $10.7 million and $6.8 million for the three-month periods ended December 31,
1995 and 1994, respectively, an increase of 57%. This increase is comparable to
the 52% increase in net sales.
OPERATING EXPENSES: Manufacturing costs decreased from 20% to 19% of
net sales due primarily to decreases in per unit material costs, primarily disks
and CDs, and increased manufacturing efficiencies. Manufacturing efficiencies
were achieved through reductions in labor and overhead as a result of refinement
of the Company's manufacturing process and continued cost-cutting measures.
Material costs decreased due to increased availability of CDs and disks and
reduced material requirements, resulting from a shift to CD-based products which
can store more information. However, in future periods, the Company expects this
trend to be offset to the extent that new products, based on increasingly
sophisticated technology, require multiple CDs.
Royalty costs increased from 7% to 9% of net sales due primarily to
higher royalty rates on certain titles resulting from the increasing
technological sophistication of the Company's products.
Selling, general and administrative expense increased $8.0 million to
$18.6 million, and from 26% to 29% of total revenues. Of this $8.0 million
increase, $4.4 million was due to increased sales and marketing expenses, $1.3
million was due to merger related costs, and $2.3 million represented increased
administrative expenses, due in part to the integration of acquired businesses.
Research and development expense, which reflects total research and
development expenditures less capitalized software development costs, increased
$3.7 million, but remained constant at approximately 15% of revenues. After
excluding $1.1 million in capitalized software development costs in the prior
year quarter, development spending increased $2.6 million, or 37%. This increase
is primarily attributable to an increase in the number of development personnel
and to increased titles in development resulting from the Company's recent
acquisitions.
NINE MONTHS ENDED DECEMBER 31, 1995 AND 1994
REVENUES: For the nine months ended December 31, 1995, net sales
increased 62% to $121.0 million and total revenues increased 62% to $122.6
million when compared to the same period in the prior year. International
revenues increased $17.8 million, or approximately 98%, over the $17.9 million
in international revenues for the comparable prior year period. For the nine
months ended December 31, 1995 as compared to the nine months ended December 31,
1994 there was a weakening of the U.S. dollar in Europe which had the effect of
increasing the dollar value of net revenues denominated in non-U.S. currencies.
The Company estimates that the weakening of the U.S. dollar accounted for
approximately $3.1 million of the increase in the Company's consolidated net
revenues for the nine months ended December 31, 1995.
The provision for customer returns and price protection reduced sales
by $20.3 million and $13.2 million for the nine-month periods ended December 31,
1995 and 1994, respectively, an increase of 59%. this increase is comparable to
the 62% increase in net sales.
OPERATING EXPENSES: Manufacturing costs for the nine month period ended
December 31, 1995 decreased from 22% to 20% of net sales. This decrease was
attributable primarily to lower per unit media costs and increased manufacturing
efficiencies.
-11-
<PAGE> 12
Manufacturing efficiencies were achieved through reductions in labor and
overhead as a result of refinement of the Company's manufacturing process and
continued cost-cutting measures. Material costs decreased due to increased
availability of CDs and disks and reduced material requirements, resulting from
a shift to CD-based products which can store more information. However, in
future periods, the Company expects this trend to be offset to the extent that
new products, based on increasingly sophisticated technology, require multiple
CDs.
Selling, general and administrative expense increased $12.3 million but
decreased from 33% to 31% of total revenues. This increase was attributable
primarily to increased spending on sales and marketing activities and to merger
related costs.
Research and development expense increased $11.2 million from 21% to
22% of total revenues, due primarily to a decrease in deferred development costs
of $5.0 million.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1995, the Company had cash, cash equivalents and
marketable investment securities aggregating approximately $85 million, a
decrease of $16 million from the balance at March 31, 1995.
The Company's working capital requirements are seasonal and are
primarily for accounts receivable. The Company's cash flow from operations for
the period was negative due primarily to an increase in net receivables of $45
million, a large portion of which occurred late in the third quarter. Net
receivables increased due to strong shipments of many of the Company's holiday
titles such as Phantasmagoria, NASCAR Racing, Police Quest 5: SWAT, Front Page
Sports: Football '96, Print Artist 3.0, The Lost Mind of Dr. Brain, and the
MasterCook series.
In the normal course of business the Company evaluates business
acquisition opportunities that will broaden its product selection for the home
consumer.
The Company believes its existing cash, cash equivalents and marketable
securities are sufficient to meet its current planned requirements for the
foreseeable future.
-12-
<PAGE> 13
PART II
OTHER INFORMATION
ITEM 5. OTHER INFORMATION
This management's discussion and analysis should be read in conjunction
with the audited financial statements appearing elsewhere in this Item 5.
On May 31, 1995 the Company merged with Pixellite, a developer of
personal printing software, in exchange for 245,779 shares of Sierra's Common
Stock. On June 20, 1995 the Company also merged with Inspiration, a developer of
strategy games, in exchange for 730,352 shares of Sierra's Common Stock. In July
the Company merged with Green Thumb Software and in September merged with Arion
Software in exchange for 87,762 and 60,196 shares of Sierra Common Stock,
respectively. Green Thumb is a developer of landscape design products and Arion
is a developer of cooking software. On November 30, 1995 the Company merged with
Papyrus, developers of NASCAR Racing and Indy Car Racing, in exchange for
approximately 1.2 million shares of Sierra's Common Stock.
These mergers have been accounted for as poolings-of-interests. The
pooling-of-interests method of accounting is intended to present as a single
interest two or more common shareholders' interests which were previously
independent; accordingly, the unaudited financial information presented herein
reflects the combined results of Sierra, Pixellite, Inspiration and Papyrus for
all periods presented. The financial statements have not been restated for the
Green Thumb and Arion mergers as these companies did not impact the Company's
operations significantly.
OVERVIEW
The Company is a leading publisher and distributor of interactive
entertainment, education and personal productivity software titles for
multimedia personal computers ("PCs"), including CD-ROM-based PC systems, and
selected emerging platforms. The multimedia PC consumer software market has
grown dramatically in recent years, driven by the increasing installed base of
multimedia PCs in the home, the proliferation of new software titles and new and
expanding distribution channels. These factors have led to the development of a
mass market for software products, which has been characterized by a rise in
importance of strong distribution channels, a significant increase in the number
of new software titles offered in the market, increased competition for limited
retail shelf space to accomodate the abundance of new titles, and increased
price pressure. Consumer reaction to different software titles is often
unpredictable. Certain titles may gain broad popularity while others may not be
received well in the market. Generally, entertainment and education software
producers differentiate themselves by their ability to design products that are
fun and/or educational, while at the same time exploiting the graphics, image,
animation, audio and video capabilities of various hardware platforms. According
to industry sources, the size of the overall market for consumer software was
estimated at $4.6 billion in 1994 and $5.8 billion in 1995 and is estimated to
increase to $10 billion in 1999. Entertainment and education software is
estimated to represent approximately 50 to 55% of the total consumer PC software
market. This growth has been fueled by increasing sales of PCs to consumers,
which are estimated to reach over 15 million in 1999 from 9.5 million in 1995.
The Company derives its revenues primarily from the sale of
entertainment and education software products. Substantially all of net sales,
ninety-five percent in fiscal 1995, represent product sold primarily through
large computer superstores, software specialty retail chains, wholesale clubs,
and mass merchandisers. The remainder represents income from licensing of
software products for software bundling arrangements. Other revenues consist of
income from the Company's 900 telephone number hintline and advertising revenue
from the Company's INTERAction! magazine. Although no one single customer
accounted for over ten percent of gross revenues in fiscal years 1995 and 1994,
the Company estimates that its top ten customers accounted for approximately 44%
of revenues in fiscal 1994 and 40% of revenues in fiscal 1995.
Sales arrangements with retailers and mass merchandisers permit them to
exchange products or receive price protection under certain circumstances. Net
sales reflects allowances for estimated returns and exchanges and price
protection. During 1995, the Company increased direct distribution sales to
superstores and wholesale clubs and experienced an increase in average price per
unit through a movement in technology platform from disk-based to CD-ROM-based
sales. These changes have led to a disproportionate increase in the reserve for
sales returns and allowances, included in accounts receivable, relative to net
sales.
A majority of product development is done internally through employees
and independent contractors. The Company's average cost for developing a product
has continued to increase substantially each year due to the greater number of
more technologically sophisticated products being developed simultaneously. In
addition, the increasing technological sophistication of the Company's products
has resulted in increased product development costs and increased the likelihood
of product release delays. The Company has been unable to pass along these
increased development costs by way of price increases due to increasing
-13-
<PAGE> 14
competition. In prior period, the Company has been able to mitigate the adverse
impact of increased development costs on operating profit through increased unit
sales and improved manufacturing margins. There can be no assurances, however,
that the Company will be able to continue to do so in future periods.
The Company estimates that product life cycles for entertainment
software products are continuing to decrease. Education software continues to
have a somewhat longer shelf life. Due to the compression of product life
cycles, increasing competition, and the increasing technological sophistication
of its products, the Company has focused its development resources on fewer
titles. This has increased the risk of revenue volatility which the Company is
seeking to minimize through a broadening of its product offerings into home
productivity and other categories.
The Company typically owns all rights to contributions to products by
independent contractors under license or assignment agreements requiring the
payment of royalties by the Company. Aggregate royalty rates on the Company's
current principal software products generally range from approximately 1% to 20%
of gross revenue derived from the product, less certain associated costs.
Royalties as a percentage of net sales were 4%, 6% and 8% in fiscal 1993, 1994
and 1995, respectively. As the Company develops more complex multimedia
products, such as CD-ROM-based products, it anticipates that royalty costs will
increase as a percentage of net sales.
The Company's revenues and earnings are highly seasonal due to
traditional consumer buying habits. The Company expects the historical trend of
realizing its highest revenues and earnings during the holiday shopping season
in the quarter ended December 31 and its seasonal lows in revenues and earnings
in the quarter ended June 30 to continue. The Company's quarterly operating
results may fluctuate throughout the year as a result of a variety of additional
factors, including delays in market acceptance, changes in platform standards,
the timing of the introduction of the Company's or its competitors' products,
the timing of orders for the Company's products and increases in product
returns. Because a majority of the unit sales for a particular product typically
occurs in the first several months after the product is introduced, the
Company's revenues may increase in a quarter in which a major product
introduction occurs and may decline in following quarters. The Company's
expenses are based, in part, on expected future revenues. A significant amount
of the Company's marketing, administrative, design and development expenses do
not vary in relation to revenues. As a result, if net revenues are below
expectations, the Company's operating results are likely to be materially and
adversely affected. During any given fiscal year, a substantial proportion of
the Company's gross sales is generated from titles introduced during that fiscal
year. During fiscal years 1993, 1994, and 1995, sales of new titles represented
52%, 55%, and 69% of gross sales, respectively. Over the next several years, the
Company expects that an increasing portion of its revenues will come from sales
of simulation, action and educational products, as well as new product lines.
The Company believes that the impact of inflation and changing prices has not
had a significant impact on income.
The entertainment and education software industry is intensely
competitive. Products in the market compete primarily on the basis of subjective
factors such as entertainment value and objective factors such as price,
graphics and sound quality. Large diversified entertainment, cable and
telecommunications companies, in addition to large software companies such as
Microsoft Corporation, are increasing their focus on the interactive
entertainment and education software market, which will result in even greater
competition for the Company. Many of these companies have substantially greater
financial, marketing and technical resources than the Company. As competition
increases, significant price competition and reduced profit margins may result.
In response to increased competition for shelf space, the Company may need to
increase marketing expenditures. In addition, competition from new technologies
(such as new hardware platforms) may reduce demand in markets in which the
Company has traditionally competed. Prolonged price competition or reduced
demand as a result of competing technologies would have a material adverse
effect on the Company's business, financial condition and operating results.
The Company generates revenues from customers throughout the world,
maintains sales and representative offices in its major foreign markets and
holds certain deposits and accounts in foreign currencies. The majority of the
Company's foreign operations are conducted by its France and United Kingdom
subsidiaries in French Francs (the Franc) and British Pound Sterling (the
Pound). Foreign revenues, expenses, currency and other accounts can be affected
by foreign currency fluctuations. Revenues generally exceed expenses and assets
exceed liabilities in non-U.S. currencies.
For the fiscal year ended March 31, 1995, there was a weakening of the
U.S. Dollar in Europe which had the effect of increasing the dollar value of net
revenues denominated in these non-U.S. currencies. The Company estimates that
the weakening of the U.S. Dollar accounted for approximately $1.1 million of the
Company's consolidated net revenues and approximately $70,000 of the
consolidated net income for the fiscal year ended March 31, 1995. Foreign
currency denominated transactions and the respective fluctuations in foreign
currency in fiscal 1994 and 1993 did not have a significant impact on results of
operations.
-14-
<PAGE> 15
RESULTS OF OPERATIONS
FISCAL YEAR ENDED MARCH 31, 1995 COMPARED TO FISCAL YEAR ENDED MARCH 31, 1994
REVENUES
Net sales of $95.8 million and total revenues of $98.9 million for
fiscal year 1995 represented increases of 36% and 34%, respectively, over the
prior fiscal year. European net sales were $18.0 million for fiscal 1995
compared to $9.8 million in the prior year. Sales outside the United States and
Europe increased $1.3 million primarily due to growth in Asia.
During fiscal 1995, 23 new products were released compared to 39 new
product releases in the prior year. In addition, four collections of series
titles were released in fiscal 1995. In fiscal 1995, 69% of gross software sales
were derived from titles released in that fiscal year while 55% of gross
software sales were derived from current releases in fiscal 1994.
The following table provides a comparison of net sales by category:
<TABLE>
<CAPTION>
Fiscal Year Ended March 31
--------------------------------
1995 1994
----------- -----------
<S> <C> <C>
Category:
Adventure ............. 32% 45%
Simulation/Strategy ... 30% 20%
Home and Education .... 13% 13%
Action/Family ......... 9% 8%
Sports ................ 13% 6%
Other ................. 3% 8%
----------- -----------
100% 100%
=========== ===========
Net Sales .................. $95,821,000 $70,712,000
</TABLE>
The provision for customer returns and price protection reduced sales
by $17.6 million in fiscal 1995 and $11.3 million in fiscal 1994, an increase of
56%. This increase in the provision for sales returns was disproportionate
relative to the 36% increase in net sales due to increased sales to superstores
and wholesale clubs.
Other revenues include income from the Company's telephone hint line
and advertising. These revenues decreased from $2.4 million to $2.1 million.
OPERATING EXPENSES
Manufacturing costs, which include material costs and manufacturing
labor and overhead, increased $1.6 million, but decreased from 28% to 23% of net
sales over the prior fiscal year. This decrease was due primarily to increased
manufacturing efficiencies, the shift from disk-based to CD-based products, and
decreases in material costs, primarily disks and CDs. Increased manufacturing
efficiencies resulted from a decrease in the total amount spent on manufacturing
labor and overhead costs from $5.0 million, or 7% of net sales, in fiscal 1994,
to $3.9 million, or 4% of net sales, in fiscal 1995. These savings were achieved
through a restructuring of the Company's manufacturing operations and
implementation of various cost cutting measures. Decreases in material costs
were the result of an increased availability of CD-ROMs and disks resulting in
lower costs to the Company. CD costs decreased approximately 19% and disk costs
decreased approximately 23% from fiscal 1994 to fiscal 1995. These cost
reductions had the effect of decreasing manufacturing costs approximately $1.0
million in fiscal 1995 from fiscal 1994. In addition to the decrease in cost of
disks and CDs, the Company has reduced its overall material cost by shifting to
CD-based products. A single CD can hold significantly more information than a
single disk.
Amortization of software development costs increased $1.3 million, but
decreased as a percentage of net sales from 12% to 10%. The increase in software
amortization costs was the result of a corresponding increase in revenue derived
from current year releases.
Royalty costs increased $3.4 million, from 6% to 8% of net sales, due
to increased sales of sports titles, which have higher royalties and increased
payments to authors due to the increasing complexity of developing multimedia
products.
Selling, general and administrative ("SG&A") expense increased $7.1
million, but decreased from 35% to 33% of total revenues. Of this increase, $3.4
million was attributable to increased spending on sales and marketing
activities, and $1 million was due to increased spending on technical and
customer support. The amount of SG&A expense attributable to the Company's
European operations increased $3.3 million but was partially offset by the $2.6
million decrease in SG&A expense attributable to INN for the period through July
1993 when INN was consolidated.
-15-
<PAGE> 16
Research and development expense, which reflects total research and
development expenditures less capitalized software development costs, increased
$4.3 million but decreased from 24% to 22% of total revenues.
NON-OPERATING INCOME OR EXPENSE
The Company recorded a gain of $19.7 million as a result of the sale of
its remaining equity ownership interest in INN to AT&T on December 19, 1994.
In December 1994 the Company also recorded $1.5 million in shareholder
litigation costs in settlement of a securities class action lawsuit filed in
December 1992. The Company determined that this settlement was in the best
interests of its shareholders by obviating the burden and expense of the
litigation process even though it believed that it had good defenses to the
claims asserted and that the Company would have prevailed at trial.
Amortization of goodwill increased approximately $0.5 million due to
approximately $1.6 million in accrued incentive payments attributable to prior
acquisitions being added to goodwill at March 31, 1994.
FISCAL YEAR ENDED MARCH 31, 1994 COMPARED TO FISCAL YEAR ENDED MARCH 31, 1993
REVENUES
Net sales of $70.7 million and total revenues of $73.1 million for the
fiscal year ended March 31, 1994 represented increases of 29% and 30%,
respectively, over the prior fiscal year. European net sales were $9.8 million
for the current year compared to $5.2 million for fiscal 1993. The increase in
European net sales was primarily attributable to the $2.7 million in net sales
from Coktel Vision, the Company's French subsidiary acquired in October 1993.
During fiscal 1994, 39 new products were released compared to 22 new
product releases in the prior year. In fiscal 1994, 55% of gross software sales
were derived from titles released in that fiscal year while in fiscal 1993 52%
of gross software sales were derived from current releases. Revenues for fiscal
1994 attributable to INN and included in the Company's consolidated financial
statements were $2.6 million compared to $2.8 million in fiscal 1993.
Other revenues increased $1.0 million over the prior year total of $1.4
million due primarily to increased hint line revenue.
OPERATING EXPENSE
Manufacturing costs decreased from 33% to 28% of net sales due
primarily to increases in manufacturing efficiencies and to decreases in disk
and CD costs. Coktel's manufacturing costs in fiscal 1994 were $0.8 million, or
31% of associated net sales.
Amortization of software development costs decreased from $11.6 million
in fiscal 1993 to $8.4 million in fiscal 1994. In fiscal 1993, the Company,
recognizing new market conditions that reduced the estimated shelf lives of
certain titles, accelerated amortization of capitalized software development
costs by an additional $1.8 million.
Royalty costs increased from 4% to 6% of net sales due to an increase
in sales from sports titles.
Selling, general and administrative ("SG&A") expense increased $1.3
million over the prior year but decreased as a percentage of total revenues from
43% to 35%. The amount of INN's SG&A expense included in the Company's
consolidated statements in fiscal 1994 (through July 26, 1993) was $2.6 million,
a decrease of $2.4 million. Coktel's SG&A expense was $0.2 million in fiscal
1994. After accounting for INN and Coktel, fiscal 1994 SG&A expense increased
$3.3 million, or 6% of total revenues. This increase was attributable primarily
to increased spending on selling and marketing activities.
Research and development ("R&D") expense, which reflects total research
and development expenditures less capitalized software development costs,
increased $4.5 million to $17.7 million. Total R&D expenditures increased by
$2.4 million to 32% of total revenues compared to 40% in fiscal 1993. However,
after excluding INN and Coktel, total R&D expenditures increased $1.1 million to
$20.8 million. This increase was attributable to the increasingly complex
technical and artistic nature of the Company's products. Although the Company's
development headcount (excluding INN and Coktel) remained relatively stable, the
Company increased its focus on education products by increasing R&D spending in
its Bright Star subsidiary by approximately $1.5 million. Part of this increase
was attributable to the fact that Bright Star was acquired after the first
quarter in fiscal 1993.
In accordance with Financial Accounting Standards Board Statement No.
86 ("FASB 86"), the Company capitalizes software development costs once
technological feasibility has been established. Within the guidelines of FASB
86, the Company determines the anticipated life of a product in months. During
fiscal 1993, in recognition of increased competition in the retail marketplace
that has tended to shorten the shelf life of the Company's products, the Company
accelerated the amortization of certain of its older titles and reduced the
estimated lives of newer titles to 6 to 18 months (from 12 to 24 months), except
for CD-ROM-based products which are amortized over 24 months. The Company
intends to continue to evaluate its amortization policy in light of any changes
in competition and product life cycles that may occur in the future.
-16-
<PAGE> 17
As a result of the Coktel acquisition, the Company incurred a charge of
$1.1 million in fiscal 1994 representing the estimated fair market value of
in-process technology expensed at the acquisition date.
LOSS FROM THE IMAGINATION NETWORK
Fiscal 1994 reflects a loss of $5.1 million for the Company's share of
INN's losses as accounted for under the equity method starting on July 27, 1993.
Prior to this date, INN's results were consolidated with the Company's results
of operations. As a result, the Company's Consolidated Statements of Operations
also reflected a $2.4 million operating loss from INN for the fiscal period
prior to July 27, 1993.
AMORTIZATION OF GOODWILL
Amortization of goodwill increased $0.2 million as a result of the
Coktel acquisition. Sierra's goodwill was increased by $2.4 million to reflect
the excess of the purchase price paid over the estimated fair value of Coktel's
net assets. This goodwill is being amortized over a seven-year period.
INCOME TAX PROVISION
The Company did not consolidate INN's results for income tax purposes
after July 26, 1993 since the Company no longer owned 80% or more of INN's stock
and therefore the losses of INN did not generate a tax benefit to the Company.
Fiscal 1994 reflected a tax benefit of $0.7 million, or 14% of the pretax loss
excluding the loss from INN under the equity method, compared to a tax benefit
of $3.3 million, or 25% of the pretax loss, in fiscal 1993.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 1995, the Company had cash, cash equivalents and
marketable investment securities aggregating approximately $101 million, an
increase of $77 million from March 31, 1994. In addition, the Company has a $10
million line of credit available. There was no outstanding balance under this
line at March 31, 1995.
The Company raised approximately $48 million in cash from a convertible
debt offering in April 1994 and $25 million from the sale of INN and the signing
of a multi-year publishing agreement with AT&T in December 1994, accounting for
most of the $75 million increase in cash, cash equivalents and marketable
investment securities.
The Company's working capital requirements are seasonal and are
primarily for accounts receivable.
In the normal course of business the Company evaluates business
acquisition opportunities that will broaden its product selection for the home
consumer.
The Company believes its existing cash, cash equivalents and marketable
investment securities, are sufficient to meet its current planned requirements
and requirements for the foreseeable future.
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<PAGE> 18
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholders
Sierra On-Line, Inc.
Bellevue, Washington
We have audited the accompanying consolidated balance sheets of Sierra On-Line,
Inc. and subsidiaries (the "Company") as of March 31, 1995 and 1994, and the
related consolidated statements of operations, stockholders' equity and cash
flows for each of the three years in the period ended March 31, 1995. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements referred to above present
fairly, in all material respects, the financial position of the Company and its
subsidiaries as of March 31, 1995 and 1994, and the results of its operations
and its cash flows for each of the three years in the period ended March 31,
1995 in conformity with generally accepted accounting principles.
The financial statements give retroactive effect to the mergers of The Pixellite
Group, Software Inspiration, Ltd., and Papyrus Design Group, Inc. with the
Company on May 31, 1995, June 20, 1995, and November 30, 1995, respectively,
which have been accounted for as poolings of interests as described in Note 1 to
the financial statements.
DELOITTE & TOUCHE LLP
Seattle, Washington
February 13, 1996
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<PAGE> 19
SIERRA ON-LINE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
MARCH 31, 1995 AND 1994
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
ASSETS
1995 1994
-------- -------
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents .......................................................... $ 50,186 $ 3,563
Marketable investment securities ................................................... 50,573 20,859
Accounts receivable, net of allowances of $7,265 and $4,091 ........................... 12,984 11,143
Inventories ........................................................................... 4,903 5,030
Deferred income taxes .............................................................. 1,777 3,051
Refundable income taxes ............................................................... 670 1,986
Other current assets (including $792 and $845 receivable from
related parties - Note 13) ....................................................... 4,262 3,207
-------- -------
Total Current Assets ........................................................... 125,355 48,839
PROPERTY, PLANT AND EQUIPMENT, net .................................................... 9,068 7,473
SOFTWARE DEVELOPMENT COSTS, net of accumulated amortization of
$8,535 in 1994 ..................................................................... 1,048 5,683
GOODWILL, net of accumulated amortization of $2,871 and $1,687 ........................ 6,498 6,119
DEFERRED INCOME TAXES ................................................................. 1,522
OTHER ASSETS .......................................................................... 1,863 791
-------- -------
$145,354 $68,905
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable ................................................................... $ 6,127 $ 4,628
Accrued compensation and related benefits .......................................... 4,118 2,051
Accrued incentive payments ......................................................... 1,562 1,620
Royalties payable (including $633 and $117 payable to a related party - Note 13) .. 2,938 1,355
Deferred revenue ................................................................... 1,261 993
Accrued interest ................................................................... 1,160 ---
Other accrued expenses (including $247 payable to related parties
in 1995 - Note 13) .............................................................. 5,028 3,926
-------- -------
Total Current Liabilities ...................................................... 22,194 14,573
DEFERRED INCOME TAXES ................................................................. --- 2,592
ADVANCES UNDER PUBLISHING AGREEMENT AND
OTHER LIABILITIES .................................................................. 5,907 634
CONVERTIBLE DEBT, net of unamortized discount and issuance costs of $1,066 ............ 34,634 ---
COMMITMENTS AND CONTINGENCIES (Note 11) .............................................. --- ---
STOCKHOLDERS' EQUITY:
Preferred stock, par value $.01 per share;
1,000,000 shares authorized, none outstanding .................................... --- ---
Common stock and paid-in capital, par value $.01 per share; 40,000,000
shares authorized; 18,726,519 and 17,371,291 shares issued and outstanding ....... 70,052 51,986
Retained earnings (deficit), including net unrealized holding
gain on marketable investment securities of $101 in 1995 ........................ 12,797 (269)
Cumulative translation adjustment .................................................. 119 (219)
-------- -------
82,968 51,498
Less common stock in treasury, 94,154 and 104,474 shares, at cost .................. 349 392
-------- -------
Total Stockholders' Equity ................................................... 82,619 51,106
-------- -------
$145,354 $68,905
======== =======
</TABLE>
See Notes to Consolidated Financial Statements.
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<PAGE> 20
SIERRA ON-LINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED MARCH 31, 1995, 1994 AND 1993
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
1995 1994 1993
------- ------- -------
<S> <C> <C> <C>
REVENUES:
Net sales ........................................... $95,821 $70,712 $54,957
Other ............................................... 2,058 2,389 1,363
------- ------- -------
97,879 73,101 56,320
------- ------- -------
OPERATING EXPENSES:
Manufacturing costs ................................. 21,663 20,058 18,402
Amortization of software development costs .......... 9,689 8,379 11,572
Royalties (including $819, $256, and $443 earned
by related party - Note 13) ...................... 7,370 4,005 2,339
Selling, general and administrative ................. 32,777 25,685 24,352
Research and development ............................ 21,967 17,686 13,202
Purchased in-process research and development ....... --- 1,102 ---
------- ------- -------
93,466 76,915 69,867
------- ------- -------
INCOME (LOSS) FROM OPERATIONS ............................ 4,413 (3,814) (13,547)
------- ------- -------
OTHER INCOME (EXPENSE):
Gain on sale of The ImagiNation Network ............. 19,739 --- ---
Equity in loss from The ImagiNation Network ......... (1,990) (5,066) ---
Shareholder litigation costs ........................ (1,500) --- ---
Interest income (including $84, $152 and $81
earned from related parties - Note 13) ........... 3,713 1,331 1,659
Interest expense .................................... (4,306) (280) (476)
Amortization of goodwill and convertible debt
issuance costs ................................... (1,212) (722) (504)
------- ------- -------
14,444 (4,737) 679
------- ------- -------
INCOME (LOSS) BEFORE INCOME TAXES ........................ 18,857 (8,551) (12,868)
INCOME TAX PROVISION (BENEFIT) ........................... 5,865 (679) (3,257)
------- ------- -------
NET INCOME (LOSS) ........................................ $12,992 $(7,872) $(9,611)
======= ======= =======
NET INCOME (LOSS) PER SHARE:
Primary ............................................. $ 0.70 $ (0.46) $ (0.57)
Fully diluted ....................................... 0.68 --- ---
WEIGHTED AVERAGE SHARES OUTSTANDING:
Primary ............................................. 18,513 17,143 16,826
Fully diluted ....................................... 22,216 --- ---
</TABLE>
See Notes to Consolidated Financial Statements.
-20-
<PAGE> 21
SIERRA ON-LINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED MARCH 31, 1995, 1994 AND 1993
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
Common Stock Retained Cumulative Total
and Paid-in Capital Earnings Translation Treasury Stock Stockholders'
Shares Amount (Deficit) Adjustment Shares Amount
Equity ---------- ------- ------- ----------- --------- ----- ------------
- --------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE, APRIL 1, 1992 16,613,483 $43,342 $17,537 $(224) 104,474 $(392) $60,263
Net loss (9,611) (9,611)
Equity contributions 4 4
Stock options exercised 138,428 501 501
Tax benefit of stock option
transactions 243 243
Shares issued to Dynamix
shareholders 24,272 221 221
Distributions (28) (28)
Foreign currency translation
adjustment (23) (23)
---------- ------- ------- ----- ------- ----- -------
BALANCE, MARCH 31, 1993 16,776,183 44,311 7,898 (247) 104,474 (392) 51,570
Net loss (7,872) (7,872)
Stock options exercised 595,108 3,256 3,256
Tax benefit of stock option
transactions 442 442
INN liquidation preference 3,977 3,977
Distributions (295) (295)
Foreign currency translation
adjustment 28 28
---------- ------- ------- ------ ------- ----- -------
BALANCE, MARCH 31, 1994 17,371,291 51,986 (269) (219) 104,474 (392) 51,106
Net income 12,992 12,992
Equity contributions 266 266
Stock options exercised 333,807 2,131 2,131
Tax benefit of stock option
transactions 1,772 1,772
Conversion of convertible
debt 1,021,421 13,897 13,897
Treasury stock issued (10,320) 43 43
Net unrealized holding gains
on marketable investment
securities available-for-sale 101 101
Distributions (27) (27)
Foreign currency translation
adjustment 338 338
---------- ------- ------- ----- ------- ----- -------
BALANCE, MARCH 31, 1995 18,726,519 $70,052 $12,797 $ 119 94,154 $(349) $82,619
========== ======= ======= ===== ======= ===== =======
</TABLE>
See Notes to Consolidated Financial Statements.
-21-
<PAGE> 22
SIERRA ON-LINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED MARCH 31, 1995, 1994 AND 1993
(IN THOUSANDS)
<TABLE>
<CAPTION>
1995 1994 1993
-------- -------- ----------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net income (loss) ......................................................... $ 12,992 $ (7,872) $ (9,611)
Reconciliation to net cash provided by (used for) operating activities:
Depreciation ............................................................ 3,298 3,085 2,732
Amortization of intangible assets and issuance costs .................... 11,153 9,102 12,077
Gain on sale of The ImagiNation Network ................................. (19,739) --- ---
Equity loss from The ImagiNation Network ................................ 1,990 5,066 ---
Purchased in-process research and development ........................... --- 1,102 ---
Provision for doubtful accounts ......................................... 829 650 1,115
Deferred income taxes ................................................... (2,840) (1,394) (1,394)
Other ................................................................... 1,880 (661) (96)
Cash provided (used) by changes in assets and liabilities:
Accounts receivable ..................................................... (2,670) (5,020) (2,230)
Inventories ............................................................. 127 (898) 842
Refundable income taxes ................................................. 3,088 1,825 (825)
Other current assets ......................................................... (151) 55 (2,064)
Software development costs .............................................. (5,037) (6,060) (9,414)
Research and development acquired ....................................... --- (2,452) ---
Other assets ............................................................ (1,090) (225) (46)
Accounts payable ........................................................ 1,498 (219) 1,201
Accrued compensation and related benefits .................................... 2,067 212 ---
Royalties payable ....................................................... 1,583 570 17
Deferred revenue ............................................................. 268 993 ---
Accrued interest ........................................................ 1,160 --- ---
Other accrued expenses .................................................. 1,093 489 2,592
Advances under publishing agreement and other liabilities ................. 4,692 (14) 105
-------- -------- ---------
Net cash provided by (used for) operating activities .................... 16,191 (1,666) (4,999)
INVESTING ACTIVITIES:
Proceeds from sale of The ImagiNation Network ............................. 19,739 --- ---
Proceeds from matured marketable investment securities .................... 40,319 67,865 119,435
Purchases of marketable investment securities ................................ (69,880) (65,550) (139,209)
Net purchases of property, plant and equipment ............................... (4,901) (3,628) (3,586)
Loan to The ImagiNation Network .............................................. (2,895) --- ---
Payment for purchase of subsidiaries, net of cash acquired
and research and development ............................................ (1,620) (2,797) (1,056)
Net repayment of advances to The ImagiNation Network ...................... --- 1,646 ---
-------- -------- ---------
Net cash used by investing activities ................................... (19,238) (2,464) (24,416)
FINANCING ACTIVITIES:
Net proceeds from convertible debt offering ............................... 48,250 --- ---
Proceeds from exercise of options and warrants ............................ 2,131 3,255 501
Other ..................................................................... (807) (255) 83
-------- -------- ---------
Net cash provided by financing activities ............................... 49,574 3,000 584
-------- -------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS ............................................................... 46,527 (1,130) (28,831)
EFFECT OF EXCHANGE RATE CHANGES ON CASH ...................................... 96 --- 27
CASH AND CASH EQUIVALENTS:
BEGINNING OF YEAR ....................................................... 3,563 4,693 33,497
-------- -------- ---------
END OF YEAR ............................................................. $ 50,186 $ 3,563 $ 4,693
======== ======== =========
</TABLE>
See Notes to Consolidated Financial Statements.
-22-
<PAGE> 23
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Supplemental disclosure of cash flow and noncash investing and financing
information for the years ended March 31 is as follows (in thousands):
<TABLE>
<CAPTION>
1995 1994 1993
------ ------ ----
<S> <C> <C> <C>
Cash paid (received) during the year for:
Income taxes .............................. $7,181 $(739) $ 23
Interest .................................. $4,578 $ (73) $(58)
</TABLE>
1995:
During fiscal 1995 the Company induced conversion of $14,300,000 of
convertible debt into 1,021,421 shares of common stock.
1994:
The Company purchased all of the capital stock of Coktel Vision for
$5,332,000. In connection with the acquisition, liabilities assumed were
as follows (in thousands):
<TABLE>
<S> <C>
Fair value of net assets acquired ................ $ 7,641
Cash paid ........................................ (5,332)
-------
Liabilities assumed .............................. $ 2,309
=======
</TABLE>
1993:
The Company purchased all of the capital stock of Bright Star for
$1,087,000. In connection with this acquisition, liabilities assumed were
as follows (in thousands):
<TABLE>
<S> <C>
Fair value of net assets acquired ................ $ 1,193
Cash paid ........................................ (1,087)
-------
Liabilities assumed .............................. $ 106
=======
</TABLE>
See Notes to Consolidated Financial Statements.
-23-
<PAGE> 24
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED MARCH 31, 1995, 1994 AND 1993
NOTE 1: BASIS OF PRESENTATION AND ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Sierra On-Line,
Inc. (Sierra), a Delaware corporation, and its wholly-owned subsidiaries,
Sierra On-Line Limited (Sierra U.K.), Dynamix, Inc. (Dynamix), Sierra On-Line
Japan, K.K. (Sierra Japan), Bright Star Technology, Inc. (Bright Star),
Coktel Vision, S.A. (Coktel), Interactive Associates, Inc., Sierra/Dynamix
International Sales Company, Inc., a foreign sales corporation, Software
Inspiration, Ltd. (Inspiration), PXL Acquisition Corp. (Pixellite), and
Papyrus Design Group, Inc. (Papyrus) (collectively referred to as the
Company). The accounts of The ImagiNation Network, Inc. (INN) were
consolidated with those of the Company through July 26, 1993 and accounted
for under the equity method until December 1994, when the Company sold its
remaining interest in INN to AT&T.
As described in Note 2, Pixellite, Inspiration and Papyrus became wholly
owned subsidiaries of Sierra On-Line, Inc. These consolidated financial
statements have been prepared under the pooling-of-interests method of
accounting and reflect the combined financial position and operating results
of Sierra, Pixellite, Inspiration and Papyrus for all periods presented. Upon
issuance of the Company's third quarter fiscal 1996 results of operations in
this Form 10-Q these consolidated financial statements will become the
historical financial statements of the Company.
All significant intercompany balances and transactions are eliminated.
BUSINESS
The Company's primary business is the development and publication of
entertainment, education and home productivity software for personal
computers for distribution in North America, Europe and Asia.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash, certificates of deposit and short
term investments with original maturities of three months or less.
MARKETABLE INVESTMENT SECURITIES
Marketable investment securities consist of municipal securities, corporate
stocks and bonds, U.S. Treasury notes, and commercial paper. The Company
adopted Statement of Financial Accounting Standard (SFAS) No. 115, Accounting
for Certain Investments in Debt and Equity Securities, effective April 1,
1994 and classified all investment securities as available-for-sale. As a
result, securities are reported at fair value with net unrealized holding
gains and losses excluded from earnings and reported in stockholders' equity.
Fair value is based upon quoted market prices using the specific
identification method. The impact of the adoption of this statement on
stockholders' equity was insignificant.
INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out method) or
market.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment is stated at cost. Depreciation and
amortization are provided using a straight-line method over estimated useful
lives ranging from approximately 2 to 18 years.
SOFTWARE DEVELOPMENT COSTS AND PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT
EXPENSES
Under the criteria set forth in SFAS No. 86, Accounting for the Costs of
Computer Software to be Sold, Leased or Otherwise Marketed, capitalization of
software development costs begins upon the establishment of technological
feasibility of the product. The establishment of technological feasibility
and the on-going assessment of the recoverability of costs require
considerable judgment by management with respect to certain external factors,
including, but not limited to, anticipated future gross product revenues,
estimated economic life and changes in software and hardware technology.
Amounts that have been capitalized under
-24-
<PAGE> 25
this statement, after consideration of the above factors, are amortized on
either a straight-line basis over the estimated useful lives of the products
(6 to 24 months) or the ratio of current product revenues to the total
revenues expected over the life of the product, whichever produces the
greater expense.
Purchased in-process research and development is charged to expense on the
date acquired if it has no alternative future use and technological
feasibility is not established.
GOODWILL
Goodwill represents the excess purchase price paid over the net assets of
acquired companies. Goodwill is amortized on a straight-line basis over seven
years.
The carrying value of goodwill is reviewed on a regular basis for the
existence of facts or circumstances both internally and externally that may
suggest impairment. To date, no such impairment has been indicated. Should
there be an impairment in the future, the Company will measure the amount of
the impairment based on the undiscounted expected future cash flows from the
impaired assets.
FOREIGN CURRENCY
Assets and liabilities denominated in foreign currencies are translated to
U.S. dollars at the exchange rate on the balance sheet date. Revenues, costs
and expenses are translated at average rates of exchange prevailing during
the year. The translation adjustment resulting from this process is presented
separately in shareholders' equity. The gains and losses from foreign
currency transactions are included in selling, general and administrative
expense in the statements of operations.
REVENUE RECOGNITION
The Company recognizes revenue in accordance with the American Institute of
Certified Public Accountants Statement of Position (SOP) No. 91-1, Software
Revenue Recognition. Revenue from product sales is recognized upon shipment,
provided no significant vendor obligations remain and collection of the
resulting receivable is deemed probable. Other insignificant vendor
obligations consisting primarily of costs associated with telephone support
to customers after delivery of software are accrued.
The Company's agreements with certain distributors and retailers permit them
to exchange products or provide price protection under certain circumstances.
The Company provides an allowance for estimated exchanges and price
protection.
During the period that INN was consolidated with the balances of the Company,
revenue from INN was recognized over the period services were provided.
ADVERTISING
The Company accounts for advertising costs in accordance with SOP No. 93-7,
Reporting on Advertising Costs. Direct response advertising is capitalized
only if customer sales can be directly correlated to the advertising and if
future benefit can be demonstrated. Capitalized advertising costs are
amortized using the straight-line method over the estimated benefit period.
Advertising expense for fiscal 1995, 1994 and 1993 was $8,750,000, $7,850,000
and $5,500,000, respectively. Amounts capitalized at March 31, 1995 and 1994
approximated $598,000 and $296,000, respectively.
INCOME TAXES (BENEFIT)
During 1994, the Company adopted Statement of Financial Accounting Standard
No. 109, Accounting for Income Taxes. Accordingly, the Company computes
income taxes using the asset and liability method, under which deferred
income taxes are provided for the temporary differences between the financial
reporting basis and the tax basis of the Company's assets and liabilities.
The cumulative effect of this change in accounting method was not
significant.
Prior to 1994, the Company utilized APB Opinion No. 11, Accounting for Income
Taxes.
NET INCOME (LOSS) PER SHARE
Net income (loss) per share is based upon the weighted average number of
common shares outstanding during the period as adjusted for the shares issued
in the mergers with Pixellite, Inspiration and Papyrus described in Note 2
and after consideration of
-25-
<PAGE> 26
the dilutive effect, if any, of stock options granted using the treasury
stock method. In addition, conversion of the Company's 6-1/2% Convertible
Subordinated Notes (see Note 8) are included in fully diluted income per
share using the if-converted method when such securities are dilutive.
STOCK SPLIT
On March 3, 1995, the Company recorded a two-for-one stock split to holders
of record on February 17, 1995. Outstanding shares, stock options and per
share data have been retroactively restated for all periods to give effect to
the stock split.
CONCENTRATION OF CREDIT RISK
Accounts receivable include amounts from geographically dispersed dealers and
distributors in the computer software industry. Concentrations of credit risk
are considered minimal and bad debts have not been significant. The Company
does not require collateral or other security to support credit sales.
RECLASSIFICATIONS
Certain reclassifications have been made to the 1993 and 1994 balances to
conform with the 1995 presentation.
NOTE 2: BUSINESS COMBINATIONS
PIXELLITE, INSPIRATION AND PAPYRUS
On May 31, 1995 the Company merged with The Pixellite Group ("Pixellite"), a
developer of personal printing software in exchange for 245,779 shares of
Sierra's common stock. On June 20, 1995 the Company also merged with Software
Inspiration, Ltd. ("Inspiration"), a developer of strategy games, in exchange
for 730,352 shares of Sierra's common stock.
On November 30, 1995 the Company merged with Papyrus Design Group
("Papyrus"), developers of NASCAR Racing and Indy Car Racing, in exchange for
approximately 1.2 million shares of Sierra's common stock.
These mergers have been accounted for as a pooling-of-interests. The
pooling-of-interests method of accounting is intended to present as a single
interest two or more common shareholders' interests which were previously
independent; accordingly, the historical financial statements for the periods
prior to the mergers are restated as though the companies had been combined.
All fees and expenses related to the merger of the combined companies will be
expensed as required under the pooling-of-interests accounting method. These
expenses have not been reflected in the consolidated statements of earnings
but will be reflected in the consolidated statement of operations of the
Company for the three and nine months ended December 31, 1995. Such fees and
expenses through December 31, 1995 total approximately $1.7 million and
include legal, accounting and finders fees.
-26-
<PAGE> 27
The following summarizes amounts previously reported by Sierra prior to the
transaction for the years ended March 31, 1995, 1994 and 1993 (in thousands,
except per share data):
<TABLE>
<CAPTION>
1995 1994 1993
------- ------- -------
<S> <C> <C> <C>
REVENUES:
Sierra ................................... $83,440 $62,745 $49,716
Pixellite, Inspiration and Papyrus ....... 14,439 10,356 6,604
------- ------- -------
Combined ................................. $97,879 $73,101 $56,320
======= ======= =======
NET INCOME (LOSS)
Sierra ................................... $11,938 $(8,676) $(8,398)
Pixellite, Inspiration and Papyrus ....... 1,054 804 (1,213)
------- ------- -------
Combined ................................. $12,992 $(7,872) $(9,611)
======= ======= =======
PRIMARY NET INCOME (LOSS) PER SHARE:
Sierra ................................... $ 0.74 $ (0.59) $ (0.58)
Pixellite, Inspiration and Papyrus ....... (0.04) 0.13 0.01
------- ------- -------
Combined ................................. $ 0.70 $ (0.46) (0.57)
======= ======= =======
FULLY DILUTED NET INCOME (LOSS) PER SHARE:
Sierra ................................... $ 0.71 $ -- $ ---
Pixellite, Inspiration and Papyrus ....... (0.03) -- ---
------- ------- -------
Combined ................................. $ 0.68 $ -- ---
======= ======= =======
</TABLE>
COKTEL
On October 29, 1993, the Company acquired Coktel Vision S.A. ("Coktel"), a
developer and publisher of educational and entertainment software products,
for an initial purchase price of approximately $5,332,000. This business
combination was accounted for as a purchase, and, accordingly, the net assets
and operations of Coktel are included in the Company's consolidated financial
statements beginning on October 29, 1993. Approximately $1,102,000 of the
purchase price was attributed to in-process research and development and
accordingly was charged to expense at the date of acquisition. Amounts
allocated to software development costs approximated $1,350,000 and amounts
allocated to goodwill were approximately $2,419,000 and will be amortized
over its estimated useful life of seven years on a straight-line basis. The
remainder of the purchase price was allocated to the net assets of Coktel and
consist primarily of current assets and current liabilities.
During the fiscal years ended March 31, 1995 and 1994, approximately
$1,562,000 and $1,313,000 were earned under this plan. At March 31, 1995 and
1994, incentive payments due approximated $1,562,000 and $1,313,000. In
December 1995 the Company amended the Coktel acquisition agreement whereby it
issued 150,000 shares of Common Stock in exchange for each former Coktel
shareholder relinquishing their rights to receive any further incentive
payments. As a result of this agreement, the Company capitalized goodwill of
approximately $4.1 million which will be amortized over its remaining useful
life of approximately five years on a straight-line basis. The Company could
be obligated to make additional payments as provided in the agreement.
BRIGHT STAR
On July 6, 1992, the Company acquired Bright Star, a developer and publisher
of educational computer software, for an initial purchase price of $1,000,000
plus transaction costs of $87,000. This business combination was accounted
for as a purchase and, accordingly, the net assets and operations of Bright
Star are included in the Company's consolidated financial statements
beginning on July 6, 1992. The $1,087,000 purchase price was assigned to the
net assets acquired based on the fair values of such assets and liabilities
at the date of acquisition. The excess of cost and liabilities assumed over
tangible assets acquired was recorded as goodwill ($929,000 at the purchase
date). Goodwill is being amortized on a straight-line basis over seven years
from the date of the original acquisition.
As part of this transaction, the common and preferred shareholders of Bright
Star as of July 2, 1992, certain key executives and a financial advisor
obtained the right to receive a maximum of up to $2,500,000 in cash or a
maximum of up to 400,000 shares of the Company's common stock over a
five-year period based on the attainment of certain revenue goals, in
addition to the $1,000,000 cash payment described above. Amounts earned by
the shareholders and executives may be paid in cash, stock or a combination
of cash and stock, at the sole discretion of the Company. Amounts received by
the financial advisor may only be paid
-27-
<PAGE> 28
in cash. These contingent amounts will be allocated to goodwill as they are
earned. In fiscal 1994, $307,000 was earned under this agreement and payable
at March 31, 1994. No amounts were earned during 1995 and 1993.
UNAUDITED PRO FORMA INFORMATION
The following unaudited combined pro forma information shows the results of
the Company's operations for the fiscal year presented had the acquisition of
Coktel occurred at the beginning of the year (in thousands, except per share
data).
<TABLE>
<CAPTION>
1994
--------
<S> <C>
Net sales ............................. $72,800
Net loss .............................. $(8,101)
Net loss per share .................... $ (0.47)
</TABLE>
This pro forma information may not be indicative of the results that actually
would have been obtained had the acquisition occurred at the beginning of the
period, and is not intended to be a projection of future results.
NOTE 3: SALE OF THE IMAGINATION NETWORK
The operating activities of INN were consolidated with those of the Company
through July 26, 1993. On July 27, 1993, the Company sold 42% of INN's voting
stock and reduced its ownership interest to 58% and reduced its voting
control such that the Company began recording INN operations utilizing the
equity method. Upon sale of its 42% interest, the Company recorded its
liquidation preference in excess of recorded book value as shareholders'
equity.
In December 1994, the Company sold its remaining equity interest in INN to
AT&T and recorded a gain of $19,739,000. The Company also entered into a
multi-year publishing agreement with AT&T to provide content for INN. The
publishing agreement provides for AT&T to fund up to $4,000,000 of the
Company's development expenditures under an existing publishing agreement and
up to $23,000,000 of Sierra's development expenditures, subject to certain
limitations, through non-refundable royalty advances. The non-refundable
royalty advances are reflected net of research and development expense. A
summary of gross research and development expense and non-refundable royalty
advances for the year ended March 31 is as follows (in thousands):
<TABLE>
<CAPTION>
1995
-------
<S> <C>
Research and development expense $23,552
Non-refundable royalty advances (1,585)
-------
$21,967
=======
</TABLE>
NOTE 4: MARKETABLE INVESTMENT SECURITIES
The Company's investments, including aggregate fair values, cost, gross
unrealized holding gains, and gross unrealized holding losses, consist of the
following at March 31 (in thousands):
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED
FAIR HOLDING HOLDING
VALUE COST GAINS LOSSES
------- ------- ---------- ----------
<S> <C> <C> <C> <C>
1995:
U.S. Government obligations $10,394 $10,357 $ 39 $ 2
Corporate securities 23,050 22,996 80 26
Commercial paper 17,129 17,067 64 2
------- ------- ---- ---
$50,573 $50,420 $183 $30
======= ======= ==== ===
1994:
U.S. Government obligations $14,939 $15,003$ --- $64
Corporate securities 544 438 106 ---
Tax-exempt municipal bonds and notes 1,831 1,830 1 ---
Commercial paper 2,915 2,915 --- ---
Money market funds 673 673 --- ---
------- ------- ---- ---
$20,902 $20,859 $107 $64
======= ======= ==== ===
</TABLE>
-28-
<PAGE> 29
Fair values of investments are based on quoted market prices on the last
business day of the fiscal year. All investments available-for-sale at March
31, 1995 will mature within one year.
NOTE 5: INVENTORIES
Inventories consist of the following at March 31 (in thousands):
<TABLE>
<CAPTION>
1995 1994
------ ------
<S> <C> <C>
Raw materials ..................... $2,841 $3,477
Work in progress .................. 65 85
Finished goods .................... 1,997 1,468
------ ------
$4,903 $5,030
====== ======
</TABLE>
NOTE 6: PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following at March 31 (in
thousands):
<TABLE>
<CAPTION>
1995 1994
-------- --------
<S> <C> <C>
Land .............................. $ 203 $ 203
Buildings and improvements ........ 3,591 3,236
Computers and equipment ........... 16,703 12,810
Furniture and fixtures ............ 1,312 785
-------- -------
21,809 17,034
Less accumulated depreciation ..... (12,741) (9,561)
-------- -------
$ 9,068 $ 7,473
======== =======
</TABLE>
NOTE 7: SOFTWARE DEVELOPMENT COSTS
In fiscal 1993, the Company reduced capitalized software development costs
for certain current titles and deferred fewer costs related to software
development due to a changing retail environment and increased competition in
the marketplace. Following careful review of its markets, the Company
recognized that the increase in the number of new titles and emerging formats
in the entertainment and educational software industries significantly
reduced the shelf life for products in these categories. To address the new
market conditions, the Company reduced capitalization of software development
costs for certain current products that had been discontinued or had
experienced shortened shelf life, expensed development costs of certain
products for new markets and new platforms where market acceptance was less
predictable and amortized new titles over a shorter life. The effect of
accelerating amortization was to increase net loss by $1,842,000, or $0.11
per common share in fiscal 1993.
NOTE 8: FINANCING ARRANGEMENTS
LINE OF CREDIT
In fiscal 1995, the Company entered into an unsecured bank line of credit
that provides for borrowings of up to $10 million, expiring August 31, 1996.
Any borrowings under this line of credit would be collateralized by
substantially all the Company's assets and incur interest at either the
bank's prime rate or IBOR plus 175 basis points at borrower's choice. The
line contains covenants requiring the Company to maintain certain financial
ratios and minimum balances in cash and cash equivalents. The Company is in
compliance with all covenants under this line of credit as of March 31, 1995.
There have been no borrowings by the Company under this line of credit to
date.
CONVERTIBLE NOTES
On April 12, 1994, the Company issued $50,000,000 in principal amount of
6-1/2% convertible subordinated notes due April 1, 2001 (the "Notes").
Interest on the Notes is payable semi-annually on April 1 and October 1 of
each year and commenced October 1, 1994. The Notes are convertible into
common stock of the Company, at a conversion price of $14.00 per share,
subject to adjustment under certain conditions. The Notes are redeemable
after April 2, 1997, at the option of the Company, at specified redemption
prices. The Notes will be subordinated to all existing and future Senior
Indebtedness (as defined in the Indenture governing the Notes) of the
Company. Issuance costs have been netted against the principal convertible
debt balance and are
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<PAGE> 30
being amortized on a straight-line basis over seven years. The fair value of
these notes at March 31, 1995 was $58,548,000 as determined by the Private
Offerings, Resales and Trading through Automated Linkages ("PORTAL") Market.
During fiscal 1995 the Company paid $1.0 million, included in interest
expense, to induce conversion of $14,300,000 of convertible debt into
1,021,421 shares of common stock. If conversion had occurred on April 1,
1994, earnings per share and weighted average shares outstanding would have
been as follows:
<TABLE>
<S> <C>
Supplementary primary earnings per share: $ 0.80
Supplementary primary weighted average shares outstanding: 18,888,000
</TABLE>
NOTE 9: INCOME TAX PROVISION (BENEFIT)
A reconciliation of the statutory federal income tax rate to the Company's
effective income tax rate is as follows for the years ended March 31:
<TABLE>
<CAPTION>
1995 1994 1993
---- ---- -----
<S> <C> <C> <C>
Statutory rate ............................................. 35.0% (35.0)% (34.0)%
State income taxes, net of federal income tax benefit ...... 3.0
Utilization of net operating losses ........................ (3.9)
Non-consolidated losses .................................... (4.5) 18.3
Foreign subsidiaries ....................................... (2.2) 3.4 1.5
Non-deductible expenses .................................... 4.5 2.1 2.1
Subchapter S Corporation earnings .......................... (1.3) (0.6) ---
Other ...................................................... 0.5 3.9 5.1
---- ---- ----
Effective rate ............................................. 31.1% (7.9)% (25.3)%
==== ==== ====
</TABLE>
The provision for income taxes (benefit) consists of the following for the
years ended March 31 (in thousands):
<TABLE>
<CAPTION>
1995 1994 1993
------- ------- -------
<S> <C> <C> <C>
Current:
Federal .................................................. $ 7,772 $ 540 $(1,686)
State .................................................... 922 32 5
Foreign .................................................. (55) 143 (182)
------- ------- -------
8,639 715 (1,863)
Deferred:
Federal .................................................. (2,298) (1,003) (1,394)
State .................................................... (268) (391) ---
Foreign .................................................. (208) --- ---
------- ------- -------
(2,774) (1,394) (1,394)
------- ------- -------
$ 5,865 $ (679) $(3,257)
======= ======= =======
</TABLE>
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<PAGE> 31
Deferred income tax liabilities (assets) reflect the tax effect of temporary
differences between the amounts of assets and liabilities for financial
reporting purposes and amounts as measured for tax purposes. A valuation
allowance against deferred tax assets has been provided for when it is more
likely than not that some or all of the deferred tax assets will not be
realized. The effect of temporary differences that cause significant portions
of deferred tax assets and liabilities are as follows at March 31 (in
thousands):
<TABLE>
<CAPTION>
1995 1994
------- -------
<S> <C> <C>
Deferred Assets:
Inventory overhead allocation ........... $ (398) $ (778)
Accrued expenses ........................ (5,638) (1,991)
Tax credits ............................. (77) (1,845)
Net operating losses .................... (334) (899)
Other ................................... (187) (717)
------- -------
Subtotal ............................ (6,634) (6,230)
Valuation allowance ..................... 3,230 3,772
------- -------
Deferred Liabilities:
Software development costs .............. 105 1,999
------- -------
$(3,299) $ (459)
======= =======
</TABLE>
NOTE 10: STOCK OPTION PLAN
The Company has reserved 4,170,000 shares of common stock for issuance under
its 1987 Stock Option Plan (the "1987 Plan") for officers, employees,
directors, vendors, consultants and independent contractors. Options granted
under this plan may be either incentive stock options or nonqualified stock
options and are granted at the fair market value of the Company's common
stock at the date of grant. Options vest and expire under the terms
established at the date of grant. The Company also has 218,556 shares
reserved for issuance under an option plan it acquired through its merger
with Papyrus (the "Papyrus Plan"). A summary of stock option transactions
under both plans follows:
<TABLE>
<CAPTION>
Range of Price
Shares Per Share
---------- -----------------
<S> <C> <C>
Options outstanding, April 1, 1992 .......... 1,464,446 0.47 - 10.13
Granted ................................. 947,700 5.62 - 8.57
Exercised ............................... (138,428) 0.47 - 5.50
Canceled ................................ (158,950) 4.58 - 7.75
---------- -----------------
Options outstanding, March 31, 1993 ......... 2,114,768 0.47 - 10.13
Granted ................................. 760,838 0.09 - 11.50
Exercised ............................... (541,108) 0.47 - 10.13
Canceled ................................ (457,366) 3.86 - 10.13
---------- -----------------
Options outstanding, March 31, 1994 ......... 1877,132 0.09 - 11.50
Granted ................................. 963,217 0.09 - 22.00
Exercised ............................... (333,807) 0.47 - 11.50
Canceled ................................ (215,482) 4.59 - 11.88
---------- -----------------
Options outstanding, March 31, 1995 ......... 2,291,060 $0.09 - 22.00
==========
</TABLE>
Of the options outstanding at March 31, 1995, 516,288 options are currently
exercisable at prices ranging from $0.09 to $11.50 per share, and 409,083
options remain available for future grants.
In March 1995, the Board of Directors approved the adoption of the 1995 Stock
Option and Award Plan (the "1995 Plan") and the Employee Stock Purchase Plan
(the "ESPP"). The Company will reserve 2,000,000 and 200,000 shares of common
stock for issuance under the 1995 Plan and the ESPP, respectively. Both plans
are subject to shareholder approval.
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<PAGE> 32
NOTE 11: COMMITMENTS AND CONTINGENCIES
LEASE COMMITMENTS
The Company has entered into long-term lease obligations for certain office
and warehouse facilities in addition to various leases for office equipment
and company vehicles. These commitments expire at various times through
fiscal 2003. The Company's expense for lease obligations for the years ended
March 31, 1995, 1994 and 1993 were $2,062,000, $1,356,000 and $740,000,
respectively.
Future minimum annual lease payments on these obligations are as follows for
the years ended March 31 (in thousands):
<TABLE>
<CAPTION>
Year Ending March 31, Payments
--------------------- --------
<S> <C>
1996 ......................... $ 2,231
1997 ......................... 2,354
1998 ......................... 2,227
1999 ......................... 1,994
2000 ......................... 1,907
Thereafter ................... 2,791
-------
Total ..................... $13,504
=======
</TABLE>
CONTINGENCIES
The Company is a defendant in various lawsuits arising in the ordinary course
of business. Management believes that losses to the Company from these
lawsuits, if any, will not have a material adverse effect on its financial
condition or results of operations. In fiscal 1995, the Company paid
approximately $1.5 million in shareholder litigation costs in settlement of a
securities class action lawsuit filed in December 1992.
NOTE 12: GEOGRAPHIC INFORMATION
The following schedule presents financial information of the Company
classified by geographic area for the years ended March 31 (in thousands):
<TABLE>
<CAPTION>
UNITED
STATES EUROPE OTHER ELIMINATIONS CONSOLIDATED
-------- ------- ------ ------------ ------------
<S> <C> <C> <C> <C> <C>
1995
Sales to unaffiliated customers $ 72,847 $17,969 $5,005 $ --- $ 95,821
Intercompany transfers 880 --- --- (880) ---
-------- ------- ------ ------- --------
$ 73,727 $17,969 $5,005 $ (880) $ 95,821
======== ======= ====== ======= ========
Income from operations $ 2,503 $ 1,910 $ --- $ --- $ 4,413
======== ======= ====== ======= ========
Identifiable assets $142,814 $ 8,238 $ (38) $(5,660) $145,354
======== ======= ====== ======= ========
1994
Sales to unaffiliated customers $ 57,896 $ 9,106 $3,710 $ --- $ 70,712
Intercompany transfers 3,901 720 --- (4,621) ---
-------- ------- ------ ------- --------
$ 61,797 $ 9,826 $3,710 $(4,621) $ 70,712
======== ======= ====== ======= ========
Income (loss) from operations $ (4,240) $ 514 $ --- $ (88) $ (3,814)
======== ======= ====== ======= ========
Identifiable assets $ 63,416 $ 5,902 $ (443) $ 30 $ 68,905
======== ======= ====== ======= ========
1993
Sales to unaffiliated customers $ 46,999 $ 5,166 $2,792 $ --- $ 54,957
Intercompany transfers 3,707 --- --- (3,707) ---
-------- ------- ------ ------- --------
$ 50,706 $ 5,166 $2,792 $(3,707) $ 54,957
======== ======= ====== ======= ========
Income (loss) from operations $(12,738) $ (980) $ --- $ 171 $(13,547)
======== ======= ====== ======= ========
Identifiable assets $ 67,543 $ 445 $ (362) $(2,432) $ 65,194
======== ======= ====== ======= ========
</TABLE>
Intercompany transfers primarily represent shipments of finished goods
inventory to international subsidiaries. The intercompany transfers are made
at transfer prices which approximate prices charged to unaffiliated customers
and have been eliminated from consolidated net sales. In the years ended
March 31, 1995 and 1994, the majority of the Company's sales to Europe were
conducted by Coktel, Papyrus and Sierra U.K. Export sales, primarily to
Canada and Asia, were $5,005,000, $3,710,000 and $2,792,000, for the years
ended March 31, 1995, 1994 and 1993, respectively.
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<PAGE> 33
NOTE 13: RELATED PARTY TRANSACTIONS
The Company pays royalties to certain independent developers, including a
director of the Company. Royalty expense related to this director was
approximately $819,000, $256,000 and $443,000 during the years ended March
31, 1995, 1994 and 1993, respectively. Royalties payable to the director at
March 31, 1995 and 1994 were $633,000 and $117,000, respectively.
From July 1993 through December 1994, the Company paid certain operating
expenses on behalf of INN. Total amounts advanced under this arrangement
totaled $456,000 and $3,271,000 during fiscal 1995 and fiscal 1994,
respectively. In April 1994, the Company accepted an unsecured Promissory
Note from INN for approximately $2,895,000. This amount was paid in full,
including interest accrued at Bank of America's prime rate, in December 1994.
As of March 31, 1995, the Company held certain notes receivable from officers
of a subsidiary. Amounts receivable from those officers at March 31, 1995 and
1994 were $792,000 and $845,000, respectively. Interest earned under these
agreements was $84,000, $152,000 and $81,000 for the years ended March 31,
1995, 1994 and 1993, respectively. The notes were paid in full in May 1995.
As of March 31, 1995 the Company owed $247,000 in dividends payable for
undistributed S Corporation earnings to the shareholders of Papyrus.
NOTE 14: QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
Summarized quarterly financial information for fiscal 1995 and fiscal 1994 is
as follows (in thousands, except per share data):
<TABLE>
<CAPTION>
Primary Fully
Net Diluted
Net Income Net
Income (Loss) Income
Revenues (Loss) Per Share Per Share
-------- ------- --------- ---------
<S> <C> <C> <C> <C>
Quarter ended:
June 30, 1994 $13,550 $(4,304) $(0.25) $ ---
September 30, 1994 20,966 (1,220) (0.07) ---
December 31, 1994(1) 41,213 17,796 0.97 0.83
March 31, 1995 22,150 720 0.05 ---
------- -------
$97,879 $12,992
======= =======
Quarter ended:
June 30, 1993(2) $12,498 $(3,475) $(0.20) $ ---
September 30, 1993 16,623 (1,325) (0.08) ---
December 31, 1993 31,370 4,010 0.22 ---
March 31, 1994 12,610 (7,082) (0.41) ---
------- -------
$73,101 $(7,872)
======= =======
</TABLE>
(1) Includes $19,739,000 gain on sale of the Company's 58% interest in The
ImagiNation Network to AT&T.
(2) One hundred percent of the operating activities of INN have been included
in the Company's operating results through July 26, 1993. Subsequent to that
date, the Company sold 42% of INN's voting stock and reduced its ownership
interest to 58% and began recording INN operations under the equity method.
NOTE 15: SUBSEQUENT EVENT
In July 1995 the Company announced the formation of a joint venture with
Pioneer Electronic Corporation to market and develop entertainment and other
software titles for the Japanese market. The joint venture requires a minimum
capital contribution from the Company of approximately $1.5 million which the
Company funded in September 1995. Under certain circumstances, the Company
may be required to contribute up to a maximum of $6.0 million over the
duration of the joint venture.
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<PAGE> 34
ITEM 6. EXHIBITS AND REPORTS OF FORM 8-K.
(a) Exhibits
Exhibit 2.1 - Agreement and Plan of Merger among Sierra On-Line,
Inc. and Papyrus Design Group, Inc. dated November
30, 1995
Exhibit 10.1 - Registration Rights Agreement between Sierra
On-Line, Inc. and the shareholders of Papyrus
Design Group, Inc. dated November 30, 1995
Exhibit 10.2 - Amendment to Acquisition Agreement between Sierra
On-Line, Inc. and Roland Oskian, Arnaud Delrue,
and Manuelle Chapoullie-Mauger
Exhibit 10.3 - Limited Liability Company Agreement of Collier
Sierra L.L.C. dated October 31, 1995
Exhibit 11.0 - Statement Re Computation of Per Share Earnings
(b) Reports on Form 8-K.
Current Report on Form 8-K dated November 30, 1995 and filed with
the Commission on December 6, 1995.
<PAGE> 35
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.
SIERRA ON-LINE, INC.
Date: May 13, 1996 By: /s/ Michael A. Brochu
--------------------------------------
Michael A. Brochu
President and Chief Operating Officer
By: /s/ Fred Schapelhouman
--------------------------------------
Fred Schapelhouman
Chief Accounting Officer
