<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1996
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 0-24936
7TH LEVEL, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 75-2480669
(State of incorporation) (I.R.S. Employer Identification No.)
1110 EAST COLLINS BOULEVARD
SUITE 122
RICHARDSON, TEXAS 75081
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (214) 498-8100
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 and (2) has been subject to such filing requirements for the past 90
days.
Yes X No
---- ---
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
COMMON STOCK, $0.01 PAR VALUE 13,468,303
(Title of Each Class) (Number of Shares Outstanding at
May 8, 1996)
<PAGE>
7TH LEVEL, INC.
Form 10-Q
For the Quarterly Period Ended March 31, 1996
Index
PART I FINANCIAL INFORMATION Page No.
--------
Item 1 Condensed Consolidated Balance Sheets at
March 31, 1996 and December 31, 1995 3
Condensed Consolidated Statements of
Operations for the Three Months Ended 4
March 31, 1996 and 1995
Condensed Consolidated Statements of
Cash Flows for the Three Months Ended 5
March 31, 1996 and 1995
Notes to Condensed Consolidated 6
Financial Statements
Item 2 Management's Discussion and Analysis of
Financial Condition and Results of 7
Operations
PART II OTHER INFORMATION
Item 6 Exhibits and Reports on Form 8-K 11
SIGNATURES 12
<PAGE>
PART I FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
7TH LEVEL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
<TABLE>
<CAPTION>
March 31, 1996 December 31, 1995
-------------- -----------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 20,928,566 $ 29,940,217
Short-term investments 10,276,786 9,706,270
Accounts receivable, net 5,341,871 6,917,280
Inventories 589,969 385,470
Other current assets 1,391,053 1,210,085
------------ ------------
Total current assets 38,528,245 48,159,322
Fixed assets, net 8,880,065 5,156,058
Intangible assets, net 1,257,815 1,100,492
Other assets 1,273,420 145,808
------------ ------------
Total assets $ 49,939,545 $ 54,561,680
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable $ 2,343,180 $ 1,263,392
Accrued expenses and other current
liabilities 3,459,511 4,074,934
------------ ------------
Total current liabilities $ 5,802,691 $ 5,338,326
Notes payable 39,179 118,902
Notes payable to related parties 581,098 581,098
Other 279,769 257,883
------------ ------------
Total liabilities $ 6,702,737 $ 6,296,209
Commitments and contingencies
Stockholders' equity:
Common Stock 134,573 130,785
Additional capital 69,665,306 69,168,061
Cumulative translation adjustment (23,943) (14,923)
Unrealized gain on investments 6,006 21,791
Accumulated deficit (26,545,134) (21,040,243)
------------ ------------
Total stockholders' equity 43,236,808 48,265,471
------------ ------------
Total liabilities and stockholders' equity $ 49,939,545 $ 54,561,680
============ ============
</TABLE>
See accompanying notes.
3
<PAGE>
7TH LEVEL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Three Months Ended
March 31, 1996 March 31, 1995
------------------ ------------------
<S> <C> <C>
Net revenues $ 4,373,088 $ 1,535,024
Cost of revenues 1,036,762 370,716
----------- -----------
Gross profit 3,336,326 1,164,308
----------- -----------
Operating expenses:
Research and product development 4,942,131 3,157,713
Sales and marketing 2,635,297 832,756
General and administrative 1,082,678 675,554
Amortization of intangible assets 29,677 565,196
----------- -----------
Total operating expenses 8,689,783 5,231,219
----------- -----------
Operating loss (5,353,457) (4,066,911)
Interest and other, net 431,489 227,549
----------- -----------
Net loss $(4,921,968) $(3,839,362)
=========== ===========
Loss per common share $ (0.37) $ (0.37)
============ ===========
Weighted average common stock and
common equivalent shares 13,225,624 10,259,688
============ ===========
</TABLE>
See accompanying notes.
4
<PAGE>
7TH LEVEL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Three Months Ended
March 31, 1996 March 31, 1995
------------------ ------------------
<S> <C> <C>
Cash flows from operating activites:
Net loss $(4,921,968) $(3,839,362)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 464,164 665,288
Write off of in-process research and development - 1,500,000
Change in operating assets and liabilities (22,740) 422,438
----------- -----------
Net cash used in operating activities (4,480,544) (1,251,636)
Cash flows from investing activities:
Acquisitions, net of cash acquired (paid) 6,323 (100,000)
Acquisition of fixed assets (4,039,860) (673,321)
Acquisition of intangible assets - (502,443)
Purchase of short-term investments (586,301) (1,717,268)
----------- -----------
Net cash used in investing activities (4,619,838) (2,993,032)
Cash flows from financing activities:
Exercise of stock options 87,186 30,544
----------- -----------
Net cash provided by financing activities 87,186 30,544
----------- -----------
Effect of exchange rate changes on cash 1,545 -
----------- -----------
Net decrease in cash (9,011,651) (4,214,124)
Cash and cash equivalents, beginning of period 29,940,217 20,001,612
----------- -----------
Cash and cash equivalents, end of period $20,928,566 $15,787,488
=========== ===========
</TABLE>
See accompanying notes.
5
<PAGE>
7TH LEVEL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation
The condensed consolidated financial statements of 7th Level, Inc.
(the "Company") are unaudited and reflect all adjustments, consisting of normal
recurring adjustments, which are, in the opinion of management, necessary for a
fair presentation of the results for the interim periods. These condensed
consolidated financial statements should be read in conjunction with the
financial statements and notes thereto included in the Company's Annual Report
on Form 10-K for the year ended December 31, 1995. The results of operations
for the three months ended March 31, 1996 are not necessarily indicative of the
results for the entire year ending December 31, 1996.
2. Loss per Share
Primary loss per share is computed by dividing the net loss by the
weighted average common stock and common stock equivalents outstanding. For the
quarters ended March 31, 1996 and 1995, the number of shares of common stock and
equivalents outstanding in the period were computed on a basis consistent with
Accounting Principles Board Opinion No. 15. Warrants and options to purchase
common stock have been excluded from the loss per share calculation because the
effect would be anti-dilutive. Fully diluted loss per share has not been
presented because the result of the computation would be anti-dilutive.
3. Acquisitions
On March 1, 1996, the Company acquired all of the outstanding stock of
PyroTechnix, Inc. ("PyroTechnix") for 300,000 shares of the Company's common
stock. The acquisition was accounted for as a pooling-of-interests. The
related acquisition costs were charged to expense during the quarter.
PyroTechnix is a software development company which specializes in realtime 3D
rendering technology. The operating results for PyroTechnix were not material
to the combined results of the two companies for all periods prior to the
acquisition and therefore results for those periods have not been restated. The
operating results of PyroTechnix have been included in the condensed
consolidated financial statements from the date of the acquisition.
During 1995, the Company acquired Distant Thunder Entertainment, Inc.
in February and Lanpro Corporation and Lanpro Localization Center, Inc. in
December. Pro forma results of operations have not been presented because the
effects of these acquisitions were not significant.
6
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following information should be read in conjunction with the financial
statements and the notes thereto and in conjunction with Management's Discussion
and Analysis of Financial Condition and Results of Operations in the Company's
Annual Report on Form 10-K for the year ended December 31, 1995. This analysis
is provided pursuant to applicable Securities and Exchange Commission
regulations and is not intended to serve as a basis for projections of future
events.
OVERVIEW
The Company's business activities include the development and acquisition
of technological and production processes to create interactive software titles
for use on multimedia PCs. The Company's efforts to date have resulted in the
development and production of TuneLand, Monty Python's Complete Waste of Time,
Take Your Best Shot, IBM's Peter and the Wolf, Battle Beast, Disney
Interactive's ("Disney") Timon & Pumbaa's Jungle Games, The Great Word Adventure
and Arcade America.
The Company will continue to make substantial expenditures to develop its
business in 1996 as the number of titles planned for release in 1996 is targeted
to increase over 50% from the six titles released in 1995/1/. The Company
expects that its operating results will fluctuate as a result of a variety of
factors, including changes in the composition of the Company's revenues, the
timing of new title releases and the seasonal nature of the market for consumer
software with peak demand in the fourth calendar quarter or holiday selling
season.
RESULTS OF OPERATIONS
Three Month Period Ended March 31, 1996 and March 31, 1995
Net revenues include product sales, OEM licensing and product
development agreements. During the first quarter of 1996, net revenues totaled
$4,373,088, which is 185% higher than the $1,535,024 revenue achieved in the
first quarter of 1995. Revenues for the first quarter of 1996 were split almost
evenly among five titles--Monty Python's Complete Waste of Time, Battle Beast,
The Great Word Adventure, TuneLand and Arcade America, while revenues for the
first quarter of 1995 resulted primarily from shipments of Monty Python's
Complete Waste of Time. Approximately 20% and 17% of the revenues for the first
quarter of 1996 and 1995, respectively, were from international sales. Revenues
from OEM licensing and product development agreements are recognized as the work
is completed under the contracts and the amounts are invoiced to the customer.
Revenues from product sales are recognized at the time of shipment but are
recorded net of allowances for price changes and returns. As of March 31, 1996,
reserves for returns and other allowances totaled approximately $1 million.
Cost of revenues during the first quarter of 1996 was $1,036,762 or
24% of net revenue, including product development, manufacturing, and royalty
and licensing costs of $240,316, $320,917, and $475,529, respectively. For the
first quarter of 1995, cost of revenues was $370,716 or 24% of sales, including
manufacturing and royalty costs of $201,121 and $169,595, respectively. The
Company expects fluctuations in gross margin in the future as changes occur in
the composition of the revenue and the associated cost of revenues.
Research and product development expenses were $4,942,131 and
$3,157,713 for the three months ended March 31, 1996 and 1995, respectively.
Research and product development costs have increased significantly because the
Company has increased its capacity from having fewer than five titles in
production in the first quarter of 1995 to having over ten titles in active
production during the first quarter of 1996. Research and product development
expenses for the first quarter of 1996 included $2,787,552 of production
expenses, $1,186,077 for software research and development and $968,502 for
expenses of the companies acquired (as described in Note 3) to provide expertise
in the development of 3D technology and graphics design and to provide the
capabilities needed to expand into the Asia Pacific
7
<PAGE>
market. During the first quarter of 1995, research and product development
expenses included $1,207,177 of production expenses, $450,536 for software
research and development costs and $1,500,000 related to the one time write down
of purchased in-process research and development associated with the acquisition
of Distant Thunder Entertainment, Inc. Excluding the one-time write off of
purchased in-process research and development, research and product development
expenses in the first quarter of 1996 increased 198% over the first quarter of
1995.
Sales and marketing expenses were $2,635,297 and $832,756 for the
three months ended March 31, 1996 and 1995, respectively. Sales and marketing
expenses for the first quarter of 1996 included $1,428,271 of expenses for
advertising, marketing and public relations and $1,207,026 of expenses related
to internal staffing. For the first quarter of 1995 expenses of $410,457 for
advertising, marketing and public relations and $422,299 related to internal
staffing were incurred. The quarterly increase of $1,802,541 over 1995 is to
support more comprehensive marketing campaigns, an expanded product offering in
1996 and increased staffing in both the US and Europe. As a percentage of net
revenues, sales and marketing expenses related to internal staffing remained
constant at 28% for the first quarter of 1996 and 1995; however, the
advertising, marketing and public relations expenses in the first quarter
increased to 33% from 27% as a percentage of net revenues in 1996 compared to
1995, most of which is attributable to sales and marketing activities related to
seven titles in the first quarter of 1996 in contrast to the first quarter of
1995 when there were only three titles.
General and administrative expenses for the first quarter of 1996 were
$1,082,678 compared with $675,554 in the first quarter of 1995. As a percentage
of net revenues, in the first quarter of 1996 general and administrative
expenses decreased to 25% from 44% in the first quarter of 1995. Included in
the first quarter of 1996 amount is approximately $100,000 of costs related to
the acquisition of PyroTechnix which was accounted for as a pooling of
interests. The increase of $307,124, excluding the acquisition costs, is 45%
over the first quarter of 1995 and was associated with the expansion of the
Company's operational and administrative support infrastructure.
Amortization of intangible expenses was $29,677 for the first quarter of
1996, and primarily represents amortization of intangible assets acquired in the
Lanpro Acquisition. These assets were acquired on December 29, 1995 and are
being amortized over periods up to seven years. Amortization of intangible
expenses during the first quarter of 1995 was $565,196 and primarily related to
intangible assets acquired in March of 1994 which were fully amortized by
December 31, 1995.
Net interest income was $431,489 for the first quarter of 1996 compared
with $227,549 in the first quarter of 1995. This change was due to higher
average cash balances which were generated by a public stock offering in late
1995.
LIQUIDITY AND CAPITAL RESOURCES
Cash and short term investments decreased $8,441,135 to $31,205,352 at
March 31, 1996, from $39,646,487 at December 31, 1995. The decrease is
primarily the result of the net loss of $4,921,968 incurred in the quarter and
$4,039,860 in asset additions for expanded computer and network capacity and
land purchased for the future site of the Dallas operations. The Company
expects to continue to fund the development of new titles and technologies and
sales and marketing activities to launch new products/1/. The Company also
anticipates making additional capital expenditures for expansion of its computer
network to include connectivity between US and international offices/1/. The
Company plans to incur approximately $4 million for the construction of the
corporate offices for Dallas operations/1/. Outside funding alternatives are
being examined to finance these construction costs. Additionally, the Company
plans to enter discussions with lenders for equipment-based financing as an
additional source of funds.
The Company anticipates that its capital resources will be sufficient
to satisfy its capital requirements for the foreseeable future/1/. To date,
however, the Company continues to operate at a loss.
8
<PAGE>
The Company's ability to achieve positive cash flow depends upon a variety of
factors, including the timeliness and success of its products, the costs of
developing, producing and marketing such products and various other factors,
some of which may be beyond the Company's control. In the future, the Company's
capital requirements will be affected by each of these factors as well as its
investments in technological and production process research/1/. If the Company
requires additional capital, it would seek such funding through additional
public or private financing/1/. There can be no assurance that the Company will
be able to obtain such financing.
STRATEGIC RELATIONSHIP STATUS
In April 1996, the Company entered into a letter agreement with Disney
to co-develop a new PC game featuring the characters from Disney's upcoming
animated film The Hunchback of Notre Dame. The Hunchback title will include
five single and multiplayer games and is planned for release in the summer of
1996/1/. This is the second in Disney's GameBreak! series and the second
collaboration between Disney and the Company. The agreement calls for Disney to
fund the development expenses for the Hunchback title and for the Company to
receive a royalty based on revenues generated by the game.
In March 1996, the Company signed a letter of intent with Future Endeavors
Incorporated ("Future Endeavors") to publish all products that are developed by
the Canadian company worldwide for an initial three-year period. The Company
plans to make a $400,000 equity investment in Future Endeavors and may make
royalty advances to fund title development in amounts ranging from $250,000 to
$500,000/1/. Additionally, the Company will provide its TopGun development tool
to Future Endeavors for use in producing titles. According to the agreement,
Future Endeavors will receive royalty payments on sales less an allowance for
returns and price concessions. Tracer, the first title of the proposed
publishing deal, is scheduled for release in mid-1996/1/.
In August 1995, the Company entered into a letter agreement with Morgan
Creek for formation of a joint venture to develop at least two computer software
titles based on Morgan Creek's character, "Ace Ventura." The first title, a
graphic adventure game is scheduled for release in the summer of 1996 and the
other title, an education oriented entertainment title is planned for release in
1997/1/. The Company will make capital contributions to the venture to fund the
costs of development of the titles and currently estimates such cost to be
$1,500,000/1/. According to the agreement, the Company will also advance to the
venture all marketing expenses and duplication costs for the titles. All
revenues of the venture are to be shared equally by the parties after repayment
of the Company's capital contributions to fund development expenses,
reimbursement of all amounts advanced by the Company to fund marketing expenses
and duplication costs and payment to the Company of a distribution fee. Morgan
Creek has been granted warrants to purchase 75,000 shares of the Company's
common stock at $20 per share and 100,000 shares of the Company's common stock
at $24 per share, which warrants expire in 1998.
During 1996, the Company anticipates forming a joint venture (the "QD7
Joint Venture") for the development, production and distribution of multimedia
products with Quincy Jones--David Salzman Entertainment ("QDE") pursuant to the
terms of a letter agreement/1/. This letter agreement provides that the Company
and QDE shall initially contribute $750,000 and $250,000, respectively, to the
QD7 Joint Venture and contemplates that additional capital contributions shall
be made only with the unanimous consent of both parties. The first title to be
developed by the QD7 Joint Venture, scheduled for release after 1996, is in the
design phase, and to date, no material expenditures or commitments have been
incurred/1/. All development, manufacturing, testing, marketing and
distribution costs will be advanced by the Company and then recouped prior to
any distribution of net receipts. Pursuant to the letter agreement, net
receipts, after the payment or reimbursement of all costs, will be applied to
the repayment to the Company and QDE of their capital contributions, with all
remaining net receipts to be shared equally by such parties.
In the normal course of business, the Company evaluates potential
acquisitions and joint ventures that may complement the Company's business.
While the Company has no present plans, commitments
9
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or agreements with respect to any material potential acquisitions or joint
ventures other than as disclosed herein, the Company may in the future
consummate acquisitions or enter into joint ventures which may require the
Company to make additional capital expenditures, and such expenditures may be
significant/1/.
- - --------------------------
/1/ This statement is a forward looking statement that involves risks and
uncertainties. Accordingly, no assurances can be given that the actual
events and results will not be materially different than the anticipated
results described in the forward looking statement. See the discussion of
the Company's business and a description of the various factors that could
materially affect the ability of the Company to achieve the anticipated
results described in the forward looking statement which is included in
Item 1 of the Company's Annual Report on Form 10-K for the year ended
December 31, 1995.
10
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7TH LEVEL, INC.
Part II. Other Information
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits - none
(b) Reports on Form 8-K
Registrant filed a Current Report on Form 8-K, dated March 5, 1996, in
respect to the acquisition of PyroTechnix, Inc. on March 1, 1996 (Item
5).
11
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7TH LEVEL, INC.
Signatures
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
7TH LEVEL, INC.
Date: May 14, 1996 By /s/ David W. Craig
------------------------------------
David W. Craig
Chief Financial Officer
(Principal Financial Officer and
Principal Accounting Officer)
12
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> MAR-31-1996
<CASH> 20,928,566
<SECURITIES> 10,276,786
<RECEIVABLES> 6,340,919
<ALLOWANCES> 990,048
<INVENTORY> 589,969
<CURRENT-ASSETS> 38,528,245
<PP&E> 8,812,396
<DEPRECIATION> 1,536,361
<TOTAL-ASSETS> 49,939,545
<CURRENT-LIABILITIES> 5,802,692
<BONDS> 0
0
0
<COMMON> 134,573
<OTHER-SE> 43,102,235
<TOTAL-LIABILITY-AND-EQUITY> 49,939,545
<SALES> 0
<TOTAL-REVENUES> 4,373,088
<CGS> 1,036,762
<TOTAL-COSTS> 8,689,783
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (431,489)
<INCOME-PRETAX> (4,921,968)
<INCOME-TAX> 0
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (4,921,968)
<EPS-PRIMARY> (.37)
<EPS-DILUTED> 0
</TABLE>
